Executive Summary
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Companies operating in China should monitor carefully the People’s Republic of China’s financial and foreign exchange (forex) regulatory landscape.
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The treasury operations and their traditional liquidity management tools usually employed in other regimes, such as intercompany loans, have not been permissible under Chinese law.
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China’s regulatory framework is a fragmented system that is based on a bifurcation between foreign and local currency movements, with greatest importance given to control of the renminbi (the local currency), foreign currency flows, and the maintenance of the exchange rate.
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Since 2005, China’s financial and forex regulators have increased their liberalization momentum, following a path that is meant to entice multinationals; this deregulation has been rolled out in a series of pilot programs.
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In volatile market conditions it is unclear how a global liquidity crunch will affect China’s momentum towards policy relaxation.
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The best advice for treasurers coping with cash and liquidity management in China: Keep close track of the large foreign and local banks since they are in the best position to monitor regulatory intentions.
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A company’s paramount asset in challenging liquidity times is its treasury talent—a treasurer should be able to anticipate and interpret the effect of the regulatory changes on the mechanics of cash management.
Introduction
Efficient cash and liquidity management in China is a multifaceted challenge—a treasurer has to scrutinize China’s regulatory environment constantly. In the past regulation has been “lyrical” at best and arbitrary at worst. Up to recent market events, it had been tending towards liberalization. The treasurer has to match various limited and unique “China-derived” treasury solutions with the capital structures of his China entities. He has to anticipate the next direction of the regulators on both the financial and the forex fronts. In turbulent global credit conditions, the mandate becomes challenging but will create, we believe, a more robust set of treasury solutions for the China market.
Understanding China’s Regulatory Environment
A China treasurer has to understand the fragmented yet punitive nature of the regulatory framework in which financial transactions and forex are regulated. A good rule of thumb is that the capital structure of an entity in China will determine what liquidity and repatriation tools are possible. If the company entered China operations fairly soon after China’s market opening, the relevant capital structures –such as equity joint ventures, cooperative joint ventures, wholly owned foreign enterprises (WOFEs), and representative offices—have varying levels of restrictive regimes for the movement of local and foreign currencies. Structures sanctioned later by the government have more favorable regulatory treatment regarding the types of liquidity tools that can be employed. For example, from July 2006, the holding company and the regional headquarter (RHQ) structure was approved in order to encourage multinational companies (MNCs) to establish their regional operations in Shanghai. Since the move was to promote MNCs, the measure might not be useful to smaller companies operating in China.
China’s regulatory backdrop for cash management is best viewed as a dual system that is designed to maintain the nonconvertible nature of the renminbi, ensuring that the renminbi forex level is maintained within a band of a basket of currencies. There are regulatory nuances to an entity’s holding, movement, and account opening of foreign currency and renminbi, as well as cash repatriation. Foreign currency accounts within China, which require the State Administration of Foreign Exchange (SAFE) approval, are designated for certain capital injection exercises and for loan proceeds. Local currency is controlled in a number of ways, including physical flow of notes, control of local currency interest rates, and mechanisms for moving funds from corporate to individual accounts.
Renminbi currency accounts have more flexibility, and are used for daily operational needs, such as payroll, payables and receivables, and trade-related activities. The capital structure of the China entity determines the types of account the treasurer may open: For example, a representative office can only open one type of renminbi account, the basic account, which covers physical cash withdrawals and payroll.
Forex control and the maintenance of the renminbi-forex rate within a designated band is controlled by SAFE. SAFE, at the time of writing, has 34 branches and 807 sub-branches, a vast improvement over the previous centralized bureaucracy. SAFE oversees foreign currency-related matters in three main areas: (1) direct investment, in which case the nature of the investment must be examined for Department of Commerce approval (is the foreign direct investment “promoted,” “restricted,” or “prohibited”?); (2) SAFE also checks that transactions involving the use of foreign currency are “genuine”—the company must submit invoices, sales contracts, receipts and/or tax certificates to the appropriate SAFE subbranch for verification; and (3) SAFE oversees the limit on an entity’s foreign debt, including foreign guarantees—for example foreign debt cannot exceed “total investment” (“registered capital” as defined by the Chinese). SAFE also provides the approval mechanism for foreign currency short-term debt levels, while a sister agency (the National Development and Reform Commission) oversees mid-term debt.
Relaxation of regulations in 2005–07 included the following: encouragement of MNCs to set up in China via the RHQ provisions; support for large Chinese corporations to set up outside China, thereby allowing renminbi flows to “temporarily” exit China; and implementation of deregulatory efforts via pilot programs. These “Nine Measures,” promulgated in December 2005, were released to allow more flexibility for both foreign and Chinese qualified MNCs to manage their liabilities, including foreign currency cash pooling for domestic group entities, establishment of offshore accounts for overseas liquidity management, lending of foreign investors’ surplus renminbi to overseas investors, execution of renminbi–foreign currency forward and renminbi–foreign currency swap transactions, and simplification of non-trade-related (or services-related) payment processes. In April 2006 the “Pudong Nine,” as they became known, allowed certain companies to open multiple foreign currency accounts and liberalized foreign currency movements. In July 2006 a portion of the “menu” of forex reform measures for holding companies with RHQ status and SAFE approval was at the very beginning of its rollout phase—just as the liquidity crisis started to become apparent on a global basis.
Cash and Liquidity Management—The Options in China
One way of looking at the myriad of overly restrictive regulations is as follows: The Chinese government, since its inception in 1949, has had as one of its dominant political mindsets the physical control or protection of the renminbi, its “people’s money.” This explains the limited options for onshore renminbi cash management and the fact that offshore entities are not allowed to hold renminbi accounts.
Renminbi Cash Management
Conventional cash and liquidity management solutions available to a treasurer in China are limited by what Chinese law permits. Direct intercompany lending is prohibited unless it is a trade-related transaction, or a payment of service, or a royalty fee. In the early days of China’s opening, trading companies established onshore utilized transfer pricing methodologies to balance the levels of renminbi working capital within China, while monies were remitted out of the country under a documented trade transaction. The documentation required for this sort of transaction has expanded over the years as the Chinese tax authorities have become involved: They check that the transfer price is on an arm’s length basis in order to assess the relevant taxes.
Second, if the Chinese company is part of a larger global trade structure of several entities, leading and lagging techniques can be used to facilitate a trade-backed transfer of funds. This technique obviously only applies to corporates with global operations that have subentities with varying levels of, and requirements for, working capital (balancing “cash-poor” entities versus “cash-rich” entities on a global basis).
The third method for circumventing the prohibition of intercompany loans is the entrustment loan structure (Figure 1). This is one of those uniquely “China-derived” structures that manages to solve the liquidity problem while satisfying the law proscribing intercompany lending. The structure basically replicates an intercompany loan; it started out as an ideal arrangement for single-source stable medium-term liquidity needs. It has since become a very elaborate structure, meeting more and more of the specific liquidity needs of onshore entities.
Under a trilateral entrustment renminbi loan structure, the designated bank is “entrusted” by a depositor to lend on funds provided solely by the depositor to a designated borrower. The bank essentially acts as an intermediary between the parties to meet the regulatory prohibition on intercompany lending. The bank receives a commission and takes no credit risk in the transactions. In this way, companies with a shortfall on internally generated cash flow can make use of the surplus that cash-rich companies have generated via a third (fee-receiving) party.
The entity placing the deposit specifies the terms of the loan to the borrower: use of loan proceeds or purpose of loan, loan amount, tenor, and interest rate. The rate must be seen to be set using arm’s length principles. Again, the Chinese tax authorities are on the scene: There is a business tax on the gross interest income earned on the loan, plus stamp duty.
Foreign banks operating in China have managed to refine the entrustment structure so that it is more efficient for group companies. For example, multiple entities within China can use the same legal structure for several transactions with simplified documentation. The advances in clearing infrastructures in China and the intensified competition among international banks entering this market have ensured that the entrustment framework is no longer a cumbersome transaction-by-transaction process.
Bank competition in China has resulted in further product development for renminbi cash management. Renminbi physical cash pooling—zero balancing (ZBA) and target balancing (TBA)—is essentially an automated daily entrustment loan structure. Physical cash pooling is a physical movement of funds between accounts of separate but legal entities with the object of achieving a “target balance” in each account at the end of the day. (If the target balance of the subaccount is set to zero, then that is the origin of the ZBA action.) Depending on the bank infrastructure, balances are physically “swept” to a header account (i.e. an active operating account). Conceptually, the renminbi cash pooling replicates intercompany cash pooling—ideal for multisource, variable-tenor liquidity needs. Also, depending on the bank, an overdraft facility may be provided, enabling the header and child accounts to deal with any overnight cash deficit position or intraday exposure. Therefore, renminbi cash pooling can cover the following treasury situations: shortage of funds on header account, surplus of funds on some of the accounts, funding of exact temporary shortages, and arrangement of sublimits for child accounts.
The China treasurer should take into account the facilities that the designated bank uses for this pooling arrangement. If dealing with a foreign bank, the treasurer should note that some cities in China are not yet fully “open” to foreign banking operations. If the entity requires cash pooling services on a pan-China basis, the treasurer needs to check that the foreign bank has arrangements in place with local banks to provide renminbi daily cash concentration services in these particular cities.
Since the cash pooling is a variation on the entrustment loan structure, again there are tax implications, namely stamp and business tax, in addition to the usual bank fees for the facility.
Renminbi Short-Term Investment or Yield Enhancement
Similarly, there are limited options open to a treasurer wishing to put surplus renminbi to use. (In conditions of squeezed liquidity worldwide this is an important consideration.) The size of the entity will determine which instruments are cost-effective given the amount of surplus renminbi to invest. For example, MNCs invest surplus renminbi balances in call and time deposits. Since they are onshore renminbi instruments, they have regulated rates. Additionally, renminbi money market and bond funds are available to the MNC treasurer.
Depending on the bank, some treasurers are able to use the entrustment loan structure to maximize renminbi yield. The surplus renminbi is lent out to an unrelated party, and the bank provides a bank guarantee. The entrustment structure limits risk to the lender to bank risk rather than corporate risk. Since the interest rate can be higher than the regulated interest for onshore bank balances, the loan structure allows for enhanced yield.
Foreign Currency Cash Management
In general, the foreign currency management options available to a China treasurer are limited by the capital structure of the entity operating in China. In general, the larger the China-based operation, the more options are available to the treasurer, both onshore and offshore. This is entirely in keeping with the long-standing Chinese regulatory trend toward favoring large companies over small ones during times of policy liberalization.
Select MNCs operating in China—those with a Chinese holding company or a RHQ in China—may be permitted, with SAFE approval, to set up a foreign currency cash pooling structure. This allows companies to lend excess foreign currency funds temporarily to related group entities domestically within China or overseas prior to formal declaration and payment of dividends (within a set, predetermined time frame). For domestic borrowing and lending of foreign currency, the arrangement is again facilitated through an entrustment loan agreement with a regulated party as an agent. As in the renminbi cash pooling scheme (above), using the entrustment loan arrangement in this manner means that the foreign currency accounts—capital accounts and settlement accounts—are transformed into a collection and payment cash flow and, depending on the bank used, automatically “swept” to a daily ZBA.
Obviously, the MNC will have to choose a bank capable of offering all the services involved in the above structure and, if required, on a pan-China basis.
Cross-border borrowing and lending of foreign currency is only open to MNCs that are designated as holding companies and have RHQ status; these transactions are structured with SAFE approval and within an entrustment arrangement. This flexibility is, at the time of writing, still in a pilot program phase.
Foreign Currency Short-Term Investment/Yield Enhancement
Foreign currency surpluses may be placed in time deposits, where the interest rate is higher than in one of the regular foreign currency accounts. It is unlikely that companies operating in China will want to keep substantial foreign currency onshore because regulations stipulate the time frame in which foreign currency, if sitting onshore, must be converted into renminbi balances.
There are a number of bank-designed treasury solutions that may be applied on a “menu basis,” depending upon how the bank offers the services. For example, for accounts receivable management, banks may offer bank acceptance draft (BAD), an early form of trade financing in China, and corporate acceptance draft (CAD) financing; accounts receivable selling (without or limited recourse), financing, and purchase; and trade financing. For accounts payable management, most banks offer a CAD program, and some offer supplier financing of varying terms and conditions. On the cash/short-term investments and short-term liabilities side of the working capital matrix, the larger banks will offer the cash pooling, auto sweeping, and overdraft facilities, as described above. Whether these services are funneled through a shared service center, or whether they are provided on a fully automated infrastructure on a pan-China basis, is likewise dependent on the bank’s operations in China.
Repatriation
Maintaining an effective cash management program and liquidity position is unfortunately only one, albeit huge, piece of the China treasury puzzle. Getting a company’s hard earned capital out of China is yet another treasury nightmare. After all the effort on the liquidity front, the treasurer is then confronted with the problem of facilitating the cash flow from China to the parent company. Not surprisingly, the Chinese regulators have not deregulated this side of the liquidity equation in favor of the foreign company operating in China, so many of the conventional (and awkward) methods for repatriation still stand.
The traditional method is repatriation via dividend payments, where the main drawback is the tax treatment, timing, and potential SAFE approval. Payment of management fees, service fees, or royalty fees is another method, although the service and fee level is subject to regulatory scrutiny, as is the case with trade-related payments (i.e. justification of transfer pricing methods). Cross-border entrusted loans can also be utilized, but the destination and timing of the surplus funds is limited. Moreover, this solution is really only applicable to holding companies and RHQs.
While many companies have looked into a preference share scheme for this purpose, it is currently still not feasible. Treasurers, therefore, have to persuade their banks to create an instrument that manages to repatriate cash, perhaps in a synthetic format. The more products that are demanded, the more likely it is that the bank’s onsite product development teams will find a way of designing the solution. In China, the treasurers provide the momentum for banks’ product development, and competition in the banking industry means that the treasurers are not ignored.
Managing in Difficult Market Conditions—Issues
Use of Treasury Products—Cost versus Benefit
The entry of foreign banks into China means that renminbi and foreign currency treasury products have been developed for companies operating in China and wishing to optimize their liquidity. The astute treasurer, however, will know that an automated, pan-China treasury product is not cheap. The cost of the treasury solution—fully automated “platforms” for auto sweeping etc.—may not be justified for small companies. As an alternative, treasurers may want to retain manual control of flows.
Your Bank in China—Domestic versus International
The choice of bank will be based on the relative size and capital structure of the entity in China. For example, a one-office WOFE in Shanghai has modest banking requirement compared to the multinational with hundreds of operations and requirements for auto sweeping, shared service centers, and a myriad of trade and distributor-related financing. The treasurer then has the extra burden of ascertaining the stability and creditworthiness of the chosen bank(s). The global credit picture has been turned upside down by recent events, so the China treasurer cannot take credit ratings as the final word on the stability of their service providers.
Finding Funding for a China Operation—The Global Liquidity Squeeze
The China treasurer is currently faced with two squeezes: funding restrictions and/or timing issues from the parent/group, and frozen facilities from local banks. While the Chinese government has committed to inject liquidity into the macro-system, it is unlikely that this will filter down to the entity level in the short term. The treasurer is faced with having to examine supplier arrangements, trade terms, and ruthless extension/shortening of the accounts receivable/accounts payable cycle—the traditional methods in these conditions.
Case Study
Capricho Douro was founded in 1999 as a luxury wine distributor, with an initial business plan that concentrated on the import and sale of select Douro ports and wines from the port-making region of Portugal to first- and second-tier cities in China. The Douro in Portugal is the oldest demarcated wine-growing region in the world, and was designated a World Heritage Site in 2001 by UNESCO. The company’s name, Capricho Douro (“golden Douro”) captures the richness of the region, not only in terms of exclusivity and rareness of brand, but also in terms of historical significance.
The initial business plan included the importation of some of the rarer port wines to Shanghai and Beijing, with the main customers being luxury hotels, corporate clients, clubs, and restaurants. In each of the major cities the product launch was in the form of a month-long series of promotional food plus beverage events in the main five and six star hotels, featuring a Portuguese chef and Portuguese menus, and exclusive port wine tastings priced for corporate clients. In addition, the port wine producers hosted tastings and competitions in these venues. Once the distribution and sales became a substantial flow, Capricho Douro expanded the operations to other cities, hotels, and venues.
In third-tier cities in China, the rollout plan for port wine distribution focused more on the less expensive table wines (vinho de mesa) and the sweeter ports, targeting affluent women as the main client base. The last stage of the product rollout included the importation and distribution of Portuguese specialty food items: sausages, olives, olive oil, etc., from the Douro region to restaurants and hotels in select first-tier cities.
Capricho Douro is a growing, Shanghai-based company with registered capital of approximately US$15 million. It is not part of a global trading company, it does not qualify as a MNC or holding company, and it is not of a size to be considered a RHQ any time soon. Therefore, its cash and liquidity solutions are limited to those available to smaller companies operating in China. The Capricho Douro treasurer wished to be aware of all the possible treasury solutions available to a company of this size. So he held a “beauty contest” with a number of foreign and local banks capable of providing facilities not only in Shanghai but also in some of the second- and third-tier cities where Capricho Douro does business.
The treasurer considered manual control of flows as an option since the bank charges for automatic pooling, etc., were seen as high. The manual option would be manageable for the treasurer, but the company operates on a pan-China level, albeit modestly. Therefore, the treasurer chose a bank that arranged for single party ZBA for all renminbi accounts, and auto sweeping to a higher-yield deposit. He arranged for the bank to shorten day sales outstanding via accounts receivable financing. He also signed on to the bank’s electronic platform for Capricho Douro’s renminbi payments, such as payroll and other short-term liabilities. Essentially, the treasurer chose a bank with pan-China connections and sufficient infrastructure to deal with the company’s fairly modest renminbi flows. The treasurer will monitor the situation onshore to see what will be possible on the repatriation front should Capricho Douro decide to capitalize on its earnings in the China market. From a strategic point of view, repatriation in current conditions would be difficult, so the treasurer is in a market intelligence mode. This suits the company’s business strategy since the sales revenues for the port wines and the table wines have remained robust in the first-tier cities despite the market conditions globally.
Making It Happen
Managing Expectations on the Regulatory Front
The legal and regulatory framework in which cash and liquidity solutions are deployed by companies in China is rapidly evolving. Prior to the global credit crisis, a China treasurer could assume that the dynamic nature of this regulatory landscape meant that the direction was definitely towards deregulation. Credit crisis market conditions invalidate that assumption. The treasurer therefore has to be extra vigilant in monitoring the following:
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changes in the regulations affecting methods of cash repatriation;
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the areas of liquidity management—accounts receivable/accounts payable, trade finance, leasing, entrustment structures—that are likely to be liberalized or tightened;
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developments in regulations that will affect banks, both foreign and local, operating in China.
On-Site Market Intelligence
China watchers assume that the regulators are most likely to enact measures that will protect the nation’s currency and give support to policies that assist troubled domestic firms and workers. The best market intelligence for the treasurer is the banking community, and he or she should monitor the regulators as closely as possible. Moreover, the banks may have input into the regulators’ next policy moves, to anticipate the following:
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What is the next likely step for the regulators in respect of relieving the liquidity squeeze?
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What is the banks’ take on future directions of financial and forex regulations?
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What types of products, platforms, and structures are in the development pipeline that would alleviate the liquidity squeeze for companies operating in China?
The Value of Human Capital
From the parent company standpoint, the starting point for successful liquidity management in China is the human asset: Sourcing and retaining sharp treasury talent in China is critical. Infrastructure can go only so far in revealing your cash position;
a good treasurer has the ability to anticipate changes and flag problems from a bank and regulatory standpoint. As treasury is a relatively new discipline in China, it is crucial that the parent is proactive in recruiting local expertise, and then motivating the new recruits to go forward. China treasury expertise that is savvy and creative is a rarity, so once found it should be nurtured.
a good treasurer has the ability to anticipate changes and flag problems from a bank and regulatory standpoint. As treasury is a relatively new discipline in China, it is crucial that the parent is proactive in recruiting local expertise, and then motivating the new recruits to go forward. China treasury expertise that is savvy and creative is a rarity, so once found it should be nurtured.
More Information
China is a relative newcomer to the world of working capital management, having spent its formative years in the “planned production” socialist style of operations. Moreover, the landscape in which liquidity is managed is evolving, especially on the regulatory side. Therefore, the bulk of relevant case studies and papers on the subject, where they do exist, are in the Chinese language. However, there is an industry source that does provide a global source of treasury information, where the majority of the case studies are in English. This is Eurofinance, a subsidiary of The Economist Group. Eurofinance produces many conferences in emerging areas of the world in which issues related to treasury and cash management issues are confronted and discussed. Among these conferences and industry groupings, the reader may find case studies from China treasurers that illustrate the latest approaches to liquidity problems in China. findings are also available on the EuroFinance website.
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