Moves by China to restrict lending activity have reinforced the widespread expectation of a credit crunch, leading to an increased focus of corporates on efficient liquidity management. This has generated new interest in tax-efficient solutions, integrated cross-bank cash management platforms and cash pooling structures. While corporates still find it profitable to park their excess funds within the country, and are aided by China's enhanced infrastructure, the changing regulatory environment is keeping the cash treasurers on their toes
Given the problems facing most Western economies, China’s vibrant marketplace looks more and more like a dream of a full-blooded capitalist. Its economic engine remains revved up, despite the initiatives of authorities to tighten the noose on the growth juggernaut. But the situation is not all what it seems to be. The country is wrestling with its own set of economic demons, including the sharp spike-up in inflation, pollution, inefficient banking and unregulated growth.
A big concern among large companies and multinationals operating in the country is the move by authorities to restrict lending activity among banks in a bid to moderate demand. However, the initiative could leave many companies that are heavily reliant on bank financing too exposed and vulnerable when financial liquidity dries up. Last year, the People’s Bank of China (PBOC), the central bank, imposed stricter lending measures for Chinese banks in an effort to cool down the overheated economy. Its guidance notes, which became effective in October, caused considerable fear in the Chinese corporate heartland.
Ernest Mak, who heads cash management for Bank of America in China, says that the expectation of a wide credit crunch have prompted many corporates to seek help from their banks on how they can better manage cash flows and thereby reduce the need to turn to third parties for borrowing. Their focus and energy have now shifted to achieving efficient liquidity management, he says. Corpo-rates are definitely giving more attention to credit lines and relationships this year, adds Tim Fleming, who heads sales for treasury and trade solutions at Citi. “These corporates need sufficient working capital all year round and ned to address any financing gap that surfaces,” he says.
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| Teoh: Highly efficient pools | |
A growing imperative
Jin Kok Teoh, head of global payments and cash management for China at HSBC, says that the current credit squeeze is expected to continue for some time. This will push corporates to look for ways to better use existing liquidity surplus that can be made immediately available, as against relying on external sources of funding. “Liquidity management will be the key to survival in the current credit environment,” says Teoh. He adds that as the US subprime crisis deepens and its impact is felt across the globe, the agenda of most corporate treasurers has shifted towards improving treasury efficiency, consolidating banking accounts, improving banking relationships and also balancing external financial costs and risks. Many of the bank’s clients have also shown significant interest in areas such as tax efficient liquidity management solutions, integrated cross-bank cash management platforms and the advantages of regional treasury centres (RTCs).
Teoh says that the local incorporation of foreign banks in China has enabled foreign banks such as HSBC to expand their branch network without geographical restrictions. Renminbi offerings to personal customers are now allowed and credit ratings are capped at sovereign risk. Teoh is positive that this regulatory liberalization will continue in China. The authorities, he says, are fully aware of the market requirements and HSBC has been assisted by new initiatives such as bulk electronic processing system (BEPS), cheque image system and foreign currency cash pooling with overnight overdraft.
Mak of Bank of America says that the increased focus on liquidity structures has benefited his bank in a big way. This is because companies that used to rely exclusively on bilateral financing have realized that it would be foolhardy to just rely on a lone core bank for liquidity support.
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| | Fleming: New imperative
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Fleming notes that most of the big corporates in China began to take a serious stab at optimizing liquidity in their platform in 2006, when the Chinese authorities signaled a tighter credit environment by raising interest rates. “Many multinational companies decided that they want to have a more integrated and centralized cash management model that improves information and control and reduces the dependence on external borrowings and this has resulted in a proliferation of RMB physical cash pooling, and more recently, foreign currency pooling as the authorities relax regulations related to foreign exchange.” Under rhe physical cash pooling structure, funds are physically swept to and from the participating companies to a pool-header account. At the moment, cash pooling without the physical movement of cash is not allowed, so that cash pooling in China is now generally understood to be sweeping for cash concentration. All the sweeps between the participating companies are regarded as entrust loans.
Physical cash pooling spreads
Four to five years ago, Citi hardly managed any physical cash pooling structures in the country. But fast forward to 2008, and the number of entrust loan structures with clients now number around 150. Ivo Distelbrink, regional sales head of treasury and trade solutions for Asia-Pacific, says that cash pooling structures are nowadays common in China and as a best practice continue to grow in popularity. Brett Krause, head of Citi global transaction services in China, says many institutions are trying to expand their RMB cash pools to include affiliated companies and joint ventures. The JVs who opt to join get higher yield for their cash but need to balance the objectives of multiple parent investors and address any counterparty risk concerns.
Distelbrink says that the foreign exchange cash pooling structures are still quite new but they have already been working on a number of such structures in China. He expects these type of structures to become more popular as the Chinese government eases restrictions on foreign currency. Krause says the Chinese regulators review and approve foreign cash structures on a case-by-case basis to ensure that the structures are appropriate and companies have the right profile.
Given that foreign currency balances from different legal entities are commingled physically under one group cash pool, China’s central bank wants to review the structure in adcvance and understand the nature of the underlying flow.
Bankers say that running a cash pool in China has a different cost structure as compared to other countries. The costs include stamp duty, a business tax and a bank commission.
Keeping the cost down
The stamp duty is paid when a participating company enters into a master agreement. 0.005% of the contract amount is charged for each party per agreement. A business tax of 5% is levied on the interest income earned by the lender. Under a cash pooling structure, business tax is not only levied when a cash-surplus participant sweeps funds into the pool-header but also when a pool-header sweeps funds to a cash-deficit participant.
Teoh of HSBC says that while clients pay one stamp duty based on the revolving entrusted loan facility amount specified in the cash pooling master agreement, they still need to estimate the projection cost amount as ‘appropriately’ as possible to effectively control the cost. “If the actual outstanding entrusted loan between the pool head and the sub-account breaches the facility amount, the customer will need to pay for the gap amount of stamp duty,” Teoh continues. He says that the business tax is withheld by the bank, based on the interest income with respect to the daily outstanding entrusted loan amount.
In general, Teoh outlines the four factors, which should be considered in order to make the tax payable more favourable to the company.
• Select the most cash-rich company as the pool head account. In this case, it will reduce the sweeping transaction cost between pool header and sub-account and outstanding entrusted loan amount and interest income accordingly;
• Discuss with the tax advisor and decide an entrusted loan interest rate within arm’s length;
• Centralize all cash positions in the pool head level or retain the surplus or deficit in the sub-account level. The latter will reduce the sweeping amount between the pool head and sub-account, outstanding entrusted loan and interest income accordingly.
• Concentrate the surplus fund and deficit with the same legal entity before pooling with different legal entities.
Different liquidity structures
The most common liquidity structure for corporate customers is the bilateral entrusted loan. The structure of a bilateral entrusted loan involves an entity with excess cash placing the surplus as a deposit with a bank and requesting the bank to lend the funds to a designated company. The entity placing the deposit specifies the terms of the entrusted loan, such as the borrower, purpose of the loan amount, tenor and interest rate, which may be set at arm’s length. The bank does not assume any of the borrower’s credit risk and acts only as an intermediary. Under this framework, companies can make efficient use of internally generated cash to fund cash-poor entities in their organization, thereby reducing the overall funding costs of the group.
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| Zhong: Potentially challenging | |
Another structure is the so-called group entrusted loan. In this form of loan, a group of companies participate in a loan framework without arranging and registering a loan, drafting an agreement or paying stamp duty for each drawdown, which is often necessary under a bilateral entrusted loan arrangement. The group entrusted loans are considered a streamlined version of the entrusted loan documentation.
Banks such as HSBC also offer a group liquidity solution. The service is a fully automatic physical cash pooling structure, which exists under the entrusted loan framework. The group liquidity solution allows negative cash balance of subsidiaries’ accounts to be covered by the surplus funds of the master account. The remaining funds in the subsidiaries’ accounts could be set to zero or a pegged number in accordance with business requirements.
There are no signs yet that the Chinese authorities are backing down from their goal of engineering the much needed slowdown of the economy this year. This despite the worrying economic picture in the US and the harsh winter snowstorms that destroyed much of the infrastructure in affected areas. Mona Zhong, who heads cash management for China at Deutsche Bank, says the tight monetary policy in China is potentially challenging for many corporates with large borrowing needs.
This is probably the reason, she adds, why many companies, especially multinationals with extensive presence in the country, have started considering streamlining their liquidity management practices.
“They are now looking at how they can better harness cash lying idle in affiliate companies,” she says. “Thus, the popularity of entrust loans structures.”
Deutsche Bank, which has recently attained local incorporation status in China, has already set up a number of renminbi-denominated cash pooling structures for clients in China.
Zhong says she considers the growing adoption of liquidity management tools such as cash sweeping under entrust loan structures to be one of the most significant developments in cash management in China this year. “It will certainly make an impact on how corporates operate in China.”
Zhong stressed that not all companies have to resort to entrust loans structures, especially if they expect their operations to remain cash-rich and very liquid in the medium and long term.
Highly liquid companies, nonetheless, can benefit from setting up third-party loan structures where they can lend excess cash to companies that are not in any way affiliated or related in China.
Zhong says there is a significant demand for credit especially from cash starved multinational companies. Some cannot rely anymore on their parent companies to provide more funding to their operations in the mainland as there may not be “borrowing gaps” available.
The situation has made it more efficient for corporates to access their true borrowing needs and strengthen relationships with their core banks. “We observed that many corporates are becoming more transparent and willing to consolidate their banking arrangements with their core partner banks that are also keen to provide the relevant RMB funding.”
Zhong says there are discussions that the Chinese government may relax its tight monetary policy given the unprecedented situation facing the global economy.
“When China introduced its credit-tightening policies early last year, the sub-prime credit crisis was less of a concern than where it is now,” Zhong says. But she also believes that a general tone has already been set by the government this year. “They are very keen to demonstrate their determination to engineer a gradual slowdown for the Chinese economy following the strong investment growth in the first three quarters of last year.”
Zhong says that there is a need to mobilize more diverse cash sources given the current scenario where banks are restricted when it comes to lending quota. Third-party entrust loans provide such an avenue.
“By facilitating entrust loans, we are not only helping our clients but possibly attract other companies to work with us in the future,” she says.
The structures are fairly straight forward but require banks to have the right client base to be able to match the right lender and borrower, and the ability to provide support and facilitate the entire negotiation process.
While there is demand for foreign exchange cash pooling services, Zhong says the process of setting up a foreign exchange cash pooling structure remains challenging since it requires a company to open specific entrust loan accounts to facilitate the sweeping apart from the operating accounts.
“Such entrust loan accounts are not required when one is creating a local currency cash pooling structure. This could make it complicated to streamline the process especially if those accounts are held in different banks.”
The industry, says Zhong, is now awaiting the launch of a domestic foreign currency clearing system by the central bank this year. This, she adds, is potentially another positive development for the country as the launch of CNAPS (China National Advanced Payment System) will offer clearing for local currency transactions.
“At the moment, domestic foreign currency clearing in China has yet to develop and this is only available via paper- based clearing in a few selected cities. Many institutions are channeling foreign currency clearing through SWIFT to address their domestic foreign currency clearing needs.” Once the syatem is launched, Deutsche Bank will participate actively in the platform to ensure that our clients can benefit from these cash management efficiencies,” Zhong adds.
