ACCOUNTS PAYABLE
Payments and Collections in China
July 27, 2006

"Many Chinese suppliers demand cash payment from Western companies, and credit terms can be difficult to extend." —Steve Monaghan, Competitive Capital ARTICLE TOOLS Print Version Reprints RECENT ARTICLES Different cities, same customers China is the region's top stop for exporting Improving wire transfers Quantifying your banks' performance

The introduction of nationwide electronic payment systems are improving the speed and reliability of payments processing in China, but a lack of payments information is still causing problems in receivables reconciliation for corporates.

Payment Instruments in China

Cash and paper
Although the payment system infrastructure is developing rapidly in China, cash is still the most popular form of consumer payment and is widely used. Credit cards and debit cards are becoming more accepted and this is set to increase further. In the corporate payment market, promissory notes, also known as drafts, are common. These can take the form of a bank-accepted draft (BAD) or a commercial-accepted draft (CAD). However, about 80 per cent of corporate payments are done by telegraphic transfer, with cash used for the remaining 20 per cent.

Cheques
Cheques in China have a lifespan of 10 days, so they are not as widely used. However, according to Aseem Goyal, regional product head for transaction banking at Standard Chartered Bank in Shanghai, the introduction of a new clearing system, the bulk-entry payment system (BEPS), could see the use of cheques increase, because it enables the bank to process the cheque as an electronic payment. According to Tuck Wai, transaction banking country head for China at ABN AMRO in Shanghai, cheques are not widely used in China and this is in line with the other North Asian markets such as South Korea and Japan. He notes the short lifespan of cheques as one reason behind this. However, cheque fraud is also a problem in China.

Electronic payment systems
There is a clear trend towards electronic payments and this is shown by the development of several national electronic payment systems. According to Wai, the payments clearing system has improved tremendously. He says: "When I first arrived in China three years ago, the nationwide clearing system had just been launched. Since then there has been a major improvement, and this June they are ready to roll out a small value clearing system, the electronic BEPS."

However, access to the Internet, which electronic payments depend upon, varies across China. According to Wai, at ABN AMRO, the coastal regions of China, where most of the industry is based, have a far better infrastructure and better access to the Internet than provinces further inland. He says: "While the bandwidth from China to places such as Hong Kong or Singapore has increased, the connection is slow because of the amount of traffic."

China's main payment system, which recently became nationwide and is operated by the People's Bank of China (PBoC), is an inter-bank system called the China National Advanced Payment System (CNAPS). Goyal, at Standard Chartered, says: "CNAPS was designed to electronically link up the PBoC's clearing centre with commercial banks, policy banks, foreign banks, and other financial institutions. CNAPS is primarily composed of a high value payment system (HVPS) and a BEPS."

HVPS, which is highly used by corporates, is a real-time gross settlement (RTGS) system and covers all locations where the PBoC either has a branch, sub-branch or rep office. In total this provides more than 2,000 clearing locations. Major banks have built direct interfaces between their back offices and the HVPS to allow for straight-through processing.

BEPS is due to be launched imminently, and, according to Goyal, this will further accelerate the use of electronic payments. He notes: "BEPS is for low-value payments with daily netting night-batch processing. Since its launch in late 2005, the PBoC has enabled some of the major cities in China with BEPS connectivity, and will cover the others by mid 2007. The major banks are in the process of building direct interfaces with this system, which will eventually provide corporates with another option for their large volume payments. The amount limitation could be a possible hindrance - presently RMB20,000 (US$2,500) - but this is expected to be revised upwards after the initial testing period. The fees will be significantly lower than HVPS, which will provide an additional incentive to use it."

Other widely used payment instruments include credit vouchers or notes, which are same-city payment instruments and the China post office (CPO) system, which is an internal payment system widely used for corporate-to-corporate (C2C) payments. According to Goyal, there are other customized solutions, whereby the large local banks initiate the payments through their branches without going through the clearing system.

Credit Term Management
Typical credit terms in China are between one and three months, although there can be a great deal of variation - up to six months or even a year. As is common all over the world, companies try to negotiate long payment terms from their suppliers, and shorter terms from their customers. Payment discounts are also offered and these are more prevalent in certain industries (e.g. IT). The credit term of a transaction can depend on the counterparty, according to Wai, at ABN AMRO. He says that extending the credit term is a prevalent practice. "If the buyer has a good reputation, typically the credit terms would be 60 days. You have an economy that is growing 10 per cent year-on-year, and there is huge domestic demand in this part of the world, so the only way to encourage your sellers to sell more is to give longer credit terms." One treasury manager for a China-based automotive firm claims: "As a whole, the company is cash rich in China. To offer customers longer credit terms simply improves our competitiveness. However, according to company policy, it is rare to extend pre-approved credit terms to customers."

Steve Monaghan, director at Competitive Capital, a consultancy specialising in channel, capital and risk, who has been working with Chinese companies that are pre-initial public offering (IPO), believes that, from a credit term standpoint, there is a significant challenge in diffusing the credit terms in China. He says: "This is due to the fact that they often play with inventory figures to disguise sales for the purpose of delaying tax payments. And many of the figures that you get are in no way real. But based on our experience working with these companies, we would estimate that typical credit terms are around 60 days, but there's huge variance within that." Many companies have large amounts of inventory because, although the sale has already been made, there is a delay in collection and the company prefers to classify the goods as inventory rather than sales, because it would be liable for tax on sales immediately.

According to Monaghan, many Chinese suppliers demand cash payment from Western companies, and credit terms can be difficult to extend. However, Monaghan says this can cause cash flow problems: "If you have Western companies demanding credit on one side and Chinese suppliers on the other demanding cash payments, these companies are in big trouble on the working capital front." Foreign investment is widely attainable, with many companies raising capital through IPOs. They are concentrating on this rather than on addressing the issue of managing their working capital and trade terms effectively. Monaghan says: "In one particular instance, an auto part company had 180 days of inventory and it was raising capital to expand capacity, when what it should have been doing is shutting the plant for six months and selling off their inventory. Therefore foreign capital has a priority over actually fixing their working capital."

Customer Receivables Risk Management
There are several trade finance instruments that are commonly used in China to mitigate the risk of customer receivables. Letters of credit (LCs) are used for 80-90 per cent of international trade with China, while for domestic trade a BAD or a CAD is used. Corporates with good credit issue CADs (which carry their risk) whereas lesser known companies rely on BADs (which carry the bank's risk). According to Goyal, at Standard Chartered, BADs are the most common instruments, since in general there is wider acceptance of bank risk, even if it is a little known bank. Goyal says: "These instruments can be discounted by the banks, which gives companies additional flexibility to manage their working capital, including taking advantage of payment discounts. Drafts are also the preferred means of financing since the interest rate is regulated and is lower than the traditional loans (the difference presently around 200 basis points)."

There are several ways of gauging the credit rating of a potential customer in China. Wai, at ABN AMRO says: "When you first deal with the counterparty or the buyer you would probably be conservative and deal with LCs. For international companies, Standard & Poor's, Fitch Ratings or Moody's can provide information on the company's rating. For domestic companies, Sinosure, the Chinese import and export insurance corporation, provides rating services. If you're dealing with international trade, typically the company would buy a policy from Sinosure to insure against credit risk."

Credit insurance is a recent trend in China. Goyal says: "Whereas traditionally the companies would have to arrange credit risk insurance themselves through the insurance companies, which can be a complex process, some banks are now working with the insurance companies to provide a one-stop end-to-end trade finance service, covering funding, insurance and reporting."

However, a more traditional way of managing customer receivables risk in China is to establish a trusting relationship with your customer on a personal level. With loss rates from unpaid customer receivables of between 2-5 per cent or more, Monaghan, of Competitive Capital, sees this as still being a vital part of business in China. He says: "The legal infrastructure is not really there, nor is adequate rigour around the collections process, so having a deep relationship with the customer base and managing their payments is instrumental. One company I know had traded with a Chinese company for many years, and when the guy that managed the relationship died, the other company simply just refused to pay."

The treasury accountant at a multinational manufacturer of industrial products based in China says that the company's main method of managing risk in its customer receivables would be to change the customer's credit limit and at the first sign of an unpaid customer invoice, the company would put the order on hold. Another treasury manager at an international electronics manufacturer based in China has a methodical approach to this issue. He says: "We have credit teams in every product division. They will evaluate the credit risk of the customers and set appropriate credit terms and limits for the customers. We also work with our bank partners to provide distributor financing to our customers. Thus, our receivable risk will be passed to the bank."

Unpaid Customer Receivables
While using trade finance instruments such as BADs or CADs can go some way to mitigating receivables risk, they can also help in the event of default under these instruments. According to Goyal, companies can go to court and sue under the China Negotiable Instrument Law, which provides protection from default and fraud. Trading under trade finance instruments helps this process. However, according Wai, at ABN AMRO, the process of claiming a debt through the courts is still very complicated and often unsuccessful. He says: "Typically what a company would do is negotiate with the buyer and see whether they could agree on some receivables and find something that is acceptable to both parties. That is one of the most practical ways of doing it. The other way would be to go to a legal firm and see if they could take action. The fact is that provincial law is still quite strong and there is no uniform way of claiming a debt, so typically the first method is preferable." The treasury manager of a large US company based in China says: "We would stop providing products to the customer and negotiate for collecting. The last resort is to take legal action if the amount is significant to our business."

Accounting Data Quality
One treasury manager working at a China-based automotive company says: "The accounting data of the dealers is not very reliable. But as a financial institution, our auto finance company has access to the central bank's credit information." Another Chinese treasury manager for an electronics multinational says: "Except for listed companies, it is quite difficult to get reliable financial data on companies in China." However, according to Wai, at ABN AMRO, the quality of information on payments has definitely improved in recent years, with the result that companies are now better able to monitor payments data. This has been driven partially by the improvement in accounting standards in China. In February this year, China's Ministry of Finance (MOF) announced the adoption of new Chinese accounting and auditing standards that are very much in line with international standards. The new accounting and auditing standards will become effective for listed enterprises from 1 January 2007. Wai says: "For listed companies, transparency is definitely improving because they have a duty to report to the exchange and they are being audited by the international audit firms. If you go into the privately-owned enterprises or the state-owned enterprises, that becomes an issue because the balance sheet itself has a lot of hidden agendas such as off-balance sheet items and dressing up unpaid loans."

Better accounting data also means easier access to information on credit risk. Goyal, at Standard Chartered, says: "Audited statements are not mandatory and many local companies file statements for tax purposes. Banks usually get management accounts but they are not audited in all cases. For large-size state-owned enterprises (SOEs) and privately-owned enterprises (POEs), however, the trend is towards using the major accounting firms for preparation of audited statements. China has also recently introduced new accounting standards that are in line with international accounting standards (IAS). These new standards will apply across all corporate entities in China. Also, there are an increasing number of credit-reference agencies that provide corporate background information and credit checks. In summary, transparency is slowly improving. In the absence of reliable or complete financial information, the banks have been able to mitigate financial risk and assess the credit worthiness of the company based on its relationship and importance to a large company (known as supply chain financing) or for subsidiaries of MNCs, based on the banks’ relationship with the parent."

According to Monaghan, of Competitive Capital, "There's no doubt there are strong moves on the regulatory front to increase accounting quality in China. The government is making the right moves, but there's a formidable challenge to the market due to the lack of international accounting standards (IAS) qualified accountants and from an enforcement standpoint you also have significant variance from province to province."

He adds: "The other thing we see within the Chinese companies is a clear lack of management reporting and management information services (MIS). The accounting manager often lacks any authority to institute change and is really subservient to the general manager. There's very clearly a need for a proper CFO role within Chinese companies and the authority to drive change. The accountants within the company are largely used for reporting purposes. Credit information is very difficult to come by. One of the tools local banks use when establishing the credit potential of the company is to have a look at the electricity and water bills to see if there's a corresponding increase with the stated growth. In many Asian markets, it is often useful to have proxies for credit."

Payments Technology and Receivables Reconciliation

Automatic reconciliation
There have been several developments in banking technology in China and some of these have directly improved the payments industry. The clearing system, CNAPS, now has the ability to carry more payments information, which has increased the possibility of automatic reconciliation. However, according to Goyal at Standard Chartered, this depends on the payment-sending bank inputting the required and complete information, which enables the recipient to upload and automatically reconcile. He adds that this frequently does not happen and receivables reconciliation continues to present a big challenge to both the companies and the banks in China.

Wai, at ABN AMRO, agrees that even if a company has the most sophisticated technology, it may still not be able to reconcile due to lack of payments data. He says: "It is not practice in China to deliver all the payments information and SWIFT is not used because all the clearing systems use Chinese characters, which makes it very difficult to integrate it with other systems such as SWIFT. There is no software that gets around this problem. All clients say that if we could come out with a solution that could match 50-60 per cent they would be more than happy to buy; but I don't think there is. What we can do is match by the amount, match by the payer." He goes on to explain that banks in China do not use SWIFT messages as part of their transaction process with international banks because they have their own internal banking system. He says: "Their own internal system is fantastic if you present it in Chinese, but if you ask them to present it in SWIFT, it is like a blank piece of paper. To convert from a Chinese character to an English character is not possible. Even the Japanese clearing system is still in Japanese."

Virtual accounts
Virtual accounts are being introduced to facilitate the process of receivables reconciliation. These are mainly being used by corporates with a large client base (e.g insurance and courier companies) and they require the bank to provide a list of account numbers to their customer. The customer can then assign one unique account number to each of its customers. Goyal notes: "These account numbers have built in information about the customer, and when the payment comes in through the clearing system, the banks are able to consolidate and format the necessary information, which can be sent to the customers for their receivable reconciliation."

For payment reconciliation, major banks will provide payment status reports (either positive or negative) through their internal platform. These reports can be interfaced with a customer's ERP system and the ERP system can auto post the status of each payment. Some major banks can also provide industry standard Bank Administration Institute (BAI) codes for more advanced auto-reconciliation solutions. Chinese companies mainly use local accounting systems and very few use international systems such as SAP or Oracle.

Payments technology used by banks is now focused on Internet-based platforms (both broadband and dial-up). According to Goyal, some banks still retain both while, in a few cases, the banks have completely moved away from dial-up modem platforms. He adds: "There have also been host-to-host (H2H) solutions implemented which provides direct connectivity between the customer's ERP system and the bank's processing engine with no bank software in between."

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