In order to address economic concerns, the Chinese authorities adopted a more stringent monetary policy during the first half of 2008 and as a result, liquidity became scarcer. Recent market turmoil has seen a shift towards a looser policy, but the effects of this loosening are yet to filter through. Consequently, companies are more focused than ever on managing working capital effectively in order to reduce funding requirements and put excess cash to good use.
Economic background
While China’s strong economic growth in recent years has provided a number of opportunities, concerns have been growing that the economy is overheating. A key issue is inflation, which rose dramatically in late 2007 and early 2008, with the Consumer Price Index (CPI) reaching a peak of 8.7% in February 2008 – the highest level for 12 years and far exceeding the central bank’s target of 4.8% for 2008.
China’s trade surplus has also been causing concern, creating pressure for the RMB to appreciate. Currency appreciation has been further driven by the creation of around 12m new private sector jobs in 2007. Given China’s export-driven economy, currency appreciation could have an adverse impact by making exports less competitive. Meanwhile the creation of asset bubbles (ie dramatic increases in asset prices) in the stock market, property market and other industries also prompted action from the authorities. This is of concern because such bubbles are liable to burst or deflate when market conditions become less hospitable.
Regulatory response
In response to these issues, the central bank moved from a ‘prudent’ to a ‘tight’ monetary policy in December 2007. This has been manifested in a number of different actions:
Interest rates.
In order to tackle inflation, the People’s Bank of China (PBOC) has repeatedly raised interest rates. The 2006 short-term borrowing rate of 5.85% was successively lifted to 7.47% before being cut to 7.20% in September 2008. The one-year deposit rate has likewise been raised from 2.25% in 2006 to the current rate of 4.14%. In contrast, interest rates previously stood unchanged for nine years until 2004.
Reserve ratio.
Banks’ reserve requirements – ie the percentage of deposits that must be set aside – have also been repeatedly increased in order to take liquidity out of the financial sector. Successive hikes brought the rate to 17.5%, up from 9.0% at the beginning of 2007. In September 2008, however, the rate was cut to 16.5% (15.5% for banks registered in an area affected by the earthquake of 12th May). The five largest banks and the Postal Savings Bank, meanwhile, are still subject to the 17.5% rate.
Reduced offshore borrowings.
Looking beyond the domestic market, measures have also been taken to reduce foreign currency lending. The quota for short-term foreign currency debt was dramatically reduced in 2007, with local banks’ quotas cut to 30% of the 2006 level and foreign banks’ quotas cut to 60% of the 2006 level.
Bank lending.
The China Banking Regulatory Commission (CBRC) has issued guidance to all limiting the growth of outstanding loans.
As a result of the measures taken by the PBOC, and assisted by the effects of slowing global economic growth, inflation is showing signs of slowing, with the CPI down to 4.9% in August 2008. Asset bubbles in the property market and stock exchanges also appear to be reducing, with residential property transactions in August 2008 down 70% from the same period last year and the Shanghai Composite Index down to 1,909.941 in mid October 2008, compared to a high of 6,124.04 in October 2007. However, these measures have also had the effect of slowing economic growth (now predicted to grow by approximately 9.0% in 2008 compared to 11.9% in 2007) as well as the liquidity available to corporates.
Chart 1: CPI (% increase on previous year)
The implications for corporates
This credit crisis has affected companies differently depending on their funding requirements. Companies that have plenty of cash have seen relatively little impact. However, sources of funding are limited in China and companies that are short of cash have been caught off guard. The impact has been particularly felt by SMEs as banks have concentrated on offering liquidity to their biggest clients.
Companies that are feeling the effects of this credit crunch have had to adapt their priorities to the worsening conditions. As Tim Fleming, Sales Head, China Treasury & Trade Solutions, Citi Global Transaction Services explains, “Last year, our clients were looking at rationalising bank relationships, process improvements, shared services and centralising their treasury processes.
These things are still very important, but they have had to move down the priority list. Suddenly our clients have had to concentrate on making sure they have adequate funding and the working capital that they need to operate.”
Optimising working capital
Working capital is defined as the difference between a company’s short-term assets and short-term liabilities. As a basic requirement, companies need to have enough current assets available to meet their current liabilities. Beyond this, companies will also aim to keep a certain amount of working capital in reserve for unforeseen liabilities. It is important to get this right as too much excess cash represents a wasted opportunity, while too little puts the company at risk of failing to meets its obligations.
Companies may adopt a conservative strategy, keeping plenty of cash in reserve, or an aggressive strategy, reducing working capital to the lowest possible level. In either case, working capital should be managed as efficiently as possible to ensure that the company is not holding more than needed so that any freed-up capital can be used effectively.
Techniques that can be employed to optimise working capital include:
Cash concentration.
Using cash management techniques to concentrate idle cash and put it to good use.
Increasing Days Payable Outstanding (DPO).
In other words, paying suppliers later so that the company holds onto its cash for as long as possible.
Reducing Days Sales Outstanding (DSO).
This is achieved by collecting due payments from customers as quickly as possible.
Reducing Days Inventories Outstanding (DIO).
This means converting raw goods to inventory and selling the product more quickly to reduce the amount of cash tied up in the manufacturing process.
In the context of the credit crunch, companies are particularly focusing on reducing idle cash balances and extending payment terms offered to suppliers. In China, this can be achieved most effectively using techniques such as cash pooling and trade finance.
Cash pooling
In a cash pooling arrangement, cash is swept to/from several accounts from/to one header account, enabling the company to optimise interest and use any idle cash more effectively. The sub accounts are left with a balance of zero or a specified target balance. In China, due to the restrictions on inter-company lending, cash pooling must be carried out using an entrust loan structure. This means that a bank must act as an intermediary.
As Tim Fleming explains, “In a tighter liquidity environment, cash pooling becomes a much higher priority as companies seek to fully utilise all cash resources within the group to reduce their external funding needs.” There may also be opportunities for companies already using such a structure to use it more effectively. For example, it may be possible to increase the number of legal entities participating in the structure and to make sure that all existing participants fully utilise the pool and leave no idle balances elsewhere.
In China, multinational corporations have sometimes found it difficult to persuade joint venture partners to participate in a cash pool as the JV partner may wish to keep any surplus cash. If the joint venture partner is short of cash, on the other hand, they may be more willing to participate as they would be set to benefit from having their cash deficit covered by the header account.
Historically companies have been reserved when it comes to negotiating with JV partners. However, in the current market the benefits of incorporating as many entities as possible into the structure may outweigh the difficulties involved in negotiating terms.
Another possible stumbling block to setting a new cash pool is the reluctance to concentrate cash balances onto one bank as this may have an impact on the legal entities’ banking relationships. This needs to be carefully considered, particularly when liquidity is scarce. However, for many the benefits of an effective cash pooling structure will be very attractive.
Third party entrust loans
A third party entrust loan is a loan arranged between two companies with a bank acting as intermediary. The advantage of this form of funding is that the interest rates are not regulated. However, in practice this type of loan can be difficult to achieve as it is necessary to find one company that is looking to borrow a particular amount and match them with a lender who is comfortable with the counterparty and looking to lend the same amount and tenor. While there has been significant interest in this type of arrangement and a small numbers of companies have been active lenders it has not been widely adopted.
Case study
Novartis China
Sherwin Zhang
Country Treasurer
Headquartered in Basel, Switzerland, Novartis is a global leader in innovative pharmaceuticals, vaccines and consumer health products. Novartis entered the China market in 1987 and has enjoyed rapid growth since then, establishing five manufacturing companies, one R&D entity, two trading companies and several representative offices to date. Annual sales in China for 2007 totalled $370m and the company’s forecast growth rate for 2008 is around 30%.
The growth of Novartis’ business units in China has been rapid but also challenging, largely due to strong sales growth and the challenging macroeconomic environment. Recently, the situation has become more complex with tighter government policies coming into force and the impact of the credit crunch starting to filter through. Although Novartis’ treasury operations in China were not directly affected by the global liquidity squeeze, banks in the region have found themselves under pressure, which has in turn negatively impacted the range of services available to corporates, particularly in relation to financing.
Novartis China has found the tighter monetary policies particularly challenging as the company aims to use its working capital as efficiently as possible. “We don’t keep extra cash in our bank accounts, so we rely on an overdraft to meet the temporary financing need arising from our daily operation,” says Sherwin Zhang, country treasurer of Novartis in China. “I heard that some companies have taken bank loans and kept the cash idle in their account, or made some structured deposits in case they need funding. Like a bear that eats a lot in the autumn to prepare for hibernating in the winter, this is a practical solution for weathering the tightening controls. However, we won’t adopt such a strategy as it reduces the cash efficiency dramatically and is against our treasury guidelines. So the challenge is tougher for us.”
Novartis China divides its funding requirements into long- and short-term, with the long-term funding need usually being covered by capital injection and/or shareholder loans. Instead of opting for a one-off infusion of funds, Novartis bases its needs on the cash flow forecast to ensure there is no idle cash in the company bank accounts. For short-term financing needs, meanwhile, an overdraft is used to support the domestic zero balancing cash pool, which was set up in 2006 through Citi. “The core part of Citi’s services is the integrated cash management system based on cash pooling and e-banking, which helps a lot in our treasury management,” says Zhang. “We selected Citi as our main bank because it has the most mature and stable cash management system.”
All of the company’s Chinese business units participate in the cash pool, which has reduced the company’s external borrowing requirements and improved its cash efficiency. “Cash flow forecasting can give us a picture of working capital and help us to plan, but only with the cash pool arrangement can we manage our cash in a very sophisticated way and control and move our cash daily rather than on a weekly or monthly basis,” explains Zhang. “Speaking of cash flow forecasting, it’s an extremely important tool to monitor working capital, but it cannot always be accurate. Many companies almost give up due to the inaccuracy of it and keep a large cash buffer instead. Only with the flexibility offered by cash pooling can we rely more on our cash flow forecast and keep the cash balance at a minimum level.”
As the company’s consolidated cash position is kept close to zero in order to maximise cash efficiency, traditional term loans no longer meet Novartis China’s needs. The company previously undertook inter-company entrusted loans but planning these required a great deal of time and energy. Meanwhile, from time to time the loans had to be rescheduled due to fluctuations in working capital, which raised the cost of this form of funding. Novartis China has never engaged in third party entrusted loan arrangements as these were deemed too inflexible.
On a global level, Novartis undertakes FX settlement activities such as cross-border netting and monthly inter-company reconciliation. However, netting is not allowed in China. Since these intragroup payments must be received and made on a gross in gross out basis on a very strict schedule, execution of the outgoing FX payments puts a lot of pressure on the Novartis Accounts Payable teams in China, due to the supporting documents requirements. Citi is one of Novartis’ FX settlement banks and Zhang appreciates the bank’s value-added service, particularly as the company is currently preparing for the new regulations, which will affect FX cash flows.
As such, the company continues to monitor new products and industry trends in order to avoid any surprises in its treasury management. Although Novartis China conducts most of its international trade with group companies, much time has been spent studying how trade finance techniques such as bank acceptance drafts and supply chain finance can be used to optimise working capital. Zhang concludes, “Trade finance will not be the key part of our strategy as the flexibility of funding is the essential aspect of our cash management and working capital control, but it’s an option for diversifying our funding resources.”
Trade finance techniques
Trade finance techniques may also be employed to smooth out the company’s working capital cycle. Bank Accepted Drafts (BADs) and Commercially Accepted Drafts (CADs) are a common form of payment in China and they can be discounted in order to expedite accounts receivable.
BADs are paper-based instruments which are guaranteed by the payer’s bank and passed to the seller, who presents the draft to their own bank for collection at the maturity date. Alternatively, the seller may choose to discount the draft in order to receive payment early on a with or without recourse basis. The minimum interest rate for discounting RMB drafts is currently set at 4.34% but in practice the rate may be 6% or more as it is market driven. In addition, the market rate has been particularly volatile this year.
CADs are similar to BADs but they are guaranteed only by the buyer and not by the bank. The payment risk is therefore higher.
While BADs in particular are a popular means of mitigating counterparty risk, however, the banks may not always be willing to issue them depending on the customer’s creditworthiness.
Supply chain finance
Another technique which has attracted much discussion in China and worldwide is supply chain financing. This is a type of receivables discounting but unlike other techniques, such as factoring, it is initiated by the buyer. Finance is provided to small suppliers at a better rate than they could otherwise obtain, based on the credit rating of their more creditworthy customers.
From the point of view of the customer, this technique is often used to alleviate pressure on suppliers when payment terms are increased. Longer payment terms, while beneficial to the buyer, can be problematic for suppliers. This in turn can cause the buyer difficulties if the supplier is obliged to raise its prices or even goes out of business. By offering suppliers supply chain financing, MNCs can improve their own working capital position without damaging that of their suppliers and at the same time enhance the relationship they have with their suppliers. The accounting treatment of supply chain financing techniques can however be ambiguous from the point of view of the supplier. Companies may wish to move the financing arrangement off balance sheet but this is usually only possible if the arrangement is carried out without recourse. Accounting advice should be sought to ensure the correct treatment.
Looking forward
While China’s economy remains strong, there continues to be a heavy reliance on exports. As a result, the exchange rate is of critical importance in ensuring that exports are priced at an attractive rate. Measures taken to relieve inflationary pressure and cool the economy, such as higher interest rates, run the risk of also contributing to currency appreciation. When combined with a global downturn, this could have a larger than desired impact on the country’s exports. Most recently, the Chinese regulator has halted RMB appreciation and moved towards a loosening of monetary policy. However, credit remains scarce as a result of the global financial crisis and economic woes.
Lessons for the future
Many were unprepared for the current credit crunch and its repercussions, and as a result there are lessons that can be learnt for the future.
One of the things that treasurers will look to achieve going forward is a more effective match between the company’s funding requirements and its lines of credit. According to Citi’s Tim Fleming, “Companies have not always had properly matched tenor requirements. They have been using short-term borrowing for long-term needs, which puts them in a vulnerable position. If the bank says you have to reduce your overdraft, it is difficult if the funds have been spent on capital equipment. The key is to plan ahead.”
In addition, the credit crunch has brought about a greater focus on the need for committed facilities. Before the crisis, in a very liquid market, companies were more relaxed in arranging lines of credit. With liquidity scarcer, companies are more likely to enter into committed facilities, preferring to pay a premium and have a firm arrangement in place.
Citi Treasury and Trade Solutions in China
Citi is proud to partner with such respected clients as Novartis to provide industry-leading cash management and trade finance and services. It is partnerships like this that in 2008 led us to again be recognized as best cash management bank in Asia in the Asiamoney polls and by The Asset. Today, we manage over 160 multi-entity cash pooling structures in China.
As a locally incorporated bank in China, Citi offers clients a full suite of domestic and cross-border cash management solutions. In addition, Citi’s presence in over 100 different countries gives our clients the global reach they need. In trade finance, our unique electronic platform CitiConnect for Trade enables clients to automate the payment process and gain access to finance online, reducing labour-intensive paper-based processes.
To further discuss your cash management and trade finance needs, we invite you to contact at Citi China:
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