RISK MANAGEMENT
Risk Management in China
Originally published on gtnews October 5, 2006

"Repatriating cash out of China is an issue for some companies because the FX is controlled and approval from the authorities is needed." -Dilys Tran, Asia director at Custom House 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

For a corporate treasurer operating in China, credit risk is one of the most difficult areas to manage. Rather than using a credit risk management method to assess risks, it is traditionally done by building up a trusting mutual relationship - known as 'guanxi' - with suppliers and customers. Most companies will use a credit facility if they are dealing with a new customer, for example, they will ask to be paid by a bank accepted draft, or use trade finance facilities such as letters of credit. If the customer proves to be reliable, then the company might consider moving to open account (whereby trade payments are made straight into the supplier's account without the use of documentary credits).

Arvinmeritor is a US-headquartered manufacturer of parts for the auto industry and it has several factory locations in China, including two just outside Shanghai. The company supplies parts to large auto manufacturers and so does most of its business on open account. However, assessing counterparty credit risk does not fall within the remit of the treasury at Arvinmeritor. Jacqueline Gu, CFO China at the company, explains: "The treasury does not have as much involvement in the credit policy as it could - it's mainly the business units that make the credit decisions on whether to work with a certain customer and what the credit terms should be."

The treasury manager of a worldwide gas and chemical company, with offices in nine provinces in China, said that its credit risk management process varies depending on the kind of business it is conducting. He said: "Our products are for industry rather than consumers and our customers are factories. The risk is lower than doing business with a trading company (consumer products are normally sold through a wholesaler). We have credit evaluations during the bidding period and then we give different credit lines and terms to customers accordingly."

However, Gu recognises that credit risk is one of the biggest challenges for her finance team, with bank accepted drafts causing difficulties for the company. "We have payment terms with our customers up to 60 or 90 days and up to the due date they should pay us cash, but sometimes they give us either a 100% bank draft that will be due in six months, or a mix of cash and bank draft," she says. The uncertainty of the form of payment creates cash management problems for the company and it is currently enforcing the rule that its sales department should only accept bankers drafts from a list of approved banks.

In the case of an unpaid debt, companies have very little power through law to reclaim the debt. Most companies prefer to manage this risk through creating good relationships with established customers. According to Gu, if the nature of the trade is a continuous supply (e.g., of industrial parts) then one option would be to stop the shipment of products until the debt has been cleared. This course of action is more likely to result in payment than trying to obtain the money through the law courts in China. Tim Fleming, director and head of cash sales for global transaction services, Citigroup China, affirms the difficulties in chasing debt with lawyers, and gives this advice: "If you're a foreign company I think you have to take a fairly conservative approach in China because your recourse through the court to recover bad debt is, ultimately, a very difficult process."

The treasury manager of the gas and chemical company told gtnews: "We stop delivery for customers that are overdue with payments by 15 days or more. We send out a warning letter through a lawyer to any customer with payments overdue by 30 days. If those two courses of action don't work, we may take legal action or seek an agent to help collect it."

Currency Risk

Currency risk in cash management
According to Fleming at Citigroup, many of the corporate customers he deals with are now "moving from the initial investment mode to actually making profits". As a result, the issues they face are payment of taxes, reinvestment in the business and investment of surplus funds, but managing excess liquidity in China is subject to extensive regulations and FX controls. According to Fleming, there are several ways for corporates to enhance return and manage excess liquidity within China:

• Use an automatic sweeping system, whereby profits are swept into a header account that has a higher rate of interest than current accounts. This is offered by some large banks.

• Use a structured deposit that protects the principal amount. By investing the interest earned on its account, the corporate can buy an option on an index linked to, for example, the euro/dollar exchange rate. Fleming says: "If the index moves in the right direction, they get an enhanced return. Of course if it moves in the wrong direction they get nothing, so they are increasing their risk."

• The People's Bank of China recently introduced its Six Measures which relaxed regulations regarding China-based companies or individuals investing in wealth management products outside China. The Measures allowed foreign banks to apply for qualified domestic institutional investor (QDII) status and also enables investors to convert RMB into foreign currency and then use that foreign currency to buy a fixed income instrument. As Fleming points out, this is a risky option if the RMB depreciates. He says: "By doing this, the investor creates a currency risk. If the RMB moves against you, although you are getting an increased interest rate, this could be offset by the currency risk." The process of using a QDII is really a yield enhancement exercise rather than a repatriation exercise because you can move the funds offshore, but only on a temporary basis. At some stage you have to bring the cash back to China.

• An entrusted loan is also a way of managing cash and minimising the counterparty risk - see part 2 of the report, China's Evolving Liquidity Management Environment, for more information on entrusted loans. Fleming says: "Through an entrusted loan the counterparty risk remains between the two parties (lender and borrower), but the bank often extends a guarantee to the lender, undertaking counterparty risk if the borrower is a client of the bank. The interest rate is a fixed rate negotiated between the two parties (lender and borrower) at levels attractive for the two of them. Banks are also not keen on doing this because it is more profitable for them to lend the money themselves." He adds that it's not always easy to match borrowers and lenders because there are many more lenders than borrowers in the market, and both the tenor and amount need to be matched.

Dilys Tran is Asia director at Custom House, a non-bank foreign exchange company, and she says: "Repatriating cash out of China is an issue for some companies because the FX is controlled and approval from the authorities is needed. Managing FX risk is still a challenge for most businesses in China." But by imposing the strict FX controls on the RMB, is the Chinese government driving companies to by-pass the RMB as a business currency? This has been known to happen, according to Tran: "Sometimes there is a private arrangement between businesses in China, so instead of paying each other in RMB, they pay in other currencies. They will then hedge the foreign currency and make foreign currency loans. Using other currencies is a way in which companies can manage their risk."

The Chinese authorities are moving towards relaxing FX controls and, at the end of 2006, foreign banks should be able to operate in RMB as well as foreign currency, in accordance with World Trade Organisation requirements. Whether or when there will be another relaxation of the RMB's peg to a basket of currencies remains to be seen. Tran at Custom House says: "With regards to RMB currency risk, at the moment there is no information from the State Administration of Foreign Exchange (SAFE) as to a clear direction on how the policy will run in future."

Currency risk hedging for payments
Until now it has only been possible for treasuries to buy foreign currency if they have a demonstrable underlying transaction. Gu, at Arvinmeritor, says: "This makes it difficult to hedge on forecasts. For instance, if I hedged with a three-month contract, the maturity date might not coincide with the payment's due date." However, a recent policy change allows the purchase of foreign currency before the actual payment date so long as there are real underlying transactions. Gu adds: "This provides some relief on future planning because we can use a hedge contract and not worry too much about the maturity date and the payable date."

She would like to set up a shared service centre (SSC) to manage FX payments and financial accounting transactions on a centralised basis to manage FX risk more effectively. In fact, she is currently considering one for financial accounting transactions based near Shanghai. However, this will not be possible for FX payments because these need to be done through the local FX authority in the district where the entity that needs the FX payment is based.

Paulus Mok is head of sales and trading, emerging markets, at Citigroup China, and he has noticed many companies becoming more concerned with FX risk recently. He says: "Many Chinese exporters have very thin margins so any volatility in the US dollar/RMB exchange rate could eat into their margins. It's something that corporations are paying a lot more attention to now."

Financial Instruments

So what are the alternatives open to corporates that need to hedge their FX risk in China? The derivatives market is still in its infancy and many types of hedging contract that are commonly available in western Europe or the US are not yet possible in China.

According to Standard Chartered Bank, based in Hong Kong, standalone NDF transactions are not allowed onshore. However, some local banks can offer RMB structured products, in which an NDF is embedded, under the approval of SAFE. An official from the bank said: "Under the current regulation, banks can do onshore forwards with net settlement but the documents should be the same as gross settlements."

Gu, at Arvinmeritor, is looking at the possibility of regional entities in China settling their own FX transactions. The only problem she has encountered is that the US-based central treasury would prefer not to decentralise this function. She says: "Due to a US GAAP accounting requirement on hedging, we want the FX hedging transactions to be settled by the local entities so we can match the risk and the hedging amount easily. However, we don't want the hedging transaction to be done in a decentralized way. We prefer the transaction to be initiated centrally in the US. We have not found a good way of doing this for the entities in China which can satisfy both of our requirements."

There is widespread interest in the FX derivatives market among corporate treasurers across China. According to Citigroup's Mok, the proportion of companies using financial market instruments is increasing although overall it is not a high percentage. Mok says: "It will take time for them to get used to hedging RMB. Some clients are taking an active role in hedging while some may choose to pass the exposure to their business counterparties when signing contracts. In terms of different types of RMB-related FX contracts, at the moment it is pretty much only forwards and FX swaps and entities in China that can execute these hedging transactions onshore. Other types of FX contracts have yet to be developed in China. However, I believe that foreign exchange options and cross-currency swaps are quite likely to be launched in the next few years with further development of the currency and capital markets in the country and support from the government on providing more flexible risk management tools to companies to manage their risks actively."

Mok adds: "Corporates would see a big benefit from the development of the derivatives market. Plain vanilla instruments are the building blocks but customers would like to see a more sophisticated market develop with more flexible hedging alternatives." He also says that one of the biggest challenges for corporates when entering into a hedging contract is that they have to provide supporting documents to prove that the exposure is needed. "With the potential deregulation in future, companies should be able to handle their hedging activities more efficiently and therefore we should see higher liquidity in the hedging markets," he claims.

Company Structure

Companies should be careful about choosing the right type of structure when they move into China, as this could affect their ability to repatriate profits and avoid the so-called liquidity trap. Tran, at Custom House, says: "How the company manages and repatriates cash and levels of taxation is highly dependent on how the company is set up - whether it is a joint venture (JV), wholly-owned foreign entity (WOFE), partly government-owned, or which industry it's in."

Not all legal entities are licensed to pay dividends out of China - this capability must be written into the business licence of the entity when it is established. Gu at Arvinmeritor has experienced this problem. She says: "Not all our legal entities have a balanced equity structure. Some legal entities may be a little over capitalised and have excess cash but no dividend capacity, while some entities may have dividend capacity but not excess cash - so we have to balance this. Overall, we are increasing the level of investment into China or utilising the excess cash within China through cash pooling, intercompany loans or reinvestments."

Setting up a holding company with several regional entities can pose a problem. A holding company can only repatriate a maximum of 90% of its profits out of China and any regional entity is also only allowed to move 90% of its total profits back into the holding company. This leads to a situation whereby only 81% of the company's consolidated profits can be repatriated out of China. "This is a fairly big disadvantage," says Citigroup's Fleming.

The JV structure can bring significant benefits. According to Fleming, one benefit is local knowledge. He says: "You're getting local distribution and guanxi, or a close relationship, with the regulator." However, a JV can pose some risk in that the investing partner has less control over the company. Fleming also adds that investing in China poses its own risks per se: "If you invest in China there is no easy exit strategy. Once you've injected that cash, you would have to find a buyer for the business to sell it and effectively find an exit."

Regulatory Risk

It is well known that financial regulations in China are constantly being introduced and updated. It can be difficult for foreign companies to keep up to date with this ever-shifting environment, but a good way to stay in tune with developments is through your bank, consultants and local news channels. Fleming says: "Compliance itself is a risk in China because, despite your best efforts, it can be very difficult to stay compliant given the amount and continuous updating of regulations. And, of course, if you're a foreign company, if you're not compliant you have a franchise risk so a tremendous effort goes into being compliant on all the different regulations."

Another aspect of the complicated regulatory system is the different interpretations of regulations under different districts and authorities in China. Fleming says: "Regulations in China are interpreted differently from one district to another. Beijing may pass a regulation that is interpreted in a totally different way from one district to another, and that also increases complexity for companies." An example of this is the regulations on corporate to individual transactions (e.g., payroll). There are two types of accounts for RMB in China: a basic and a general account. According to Fleming, the basic account can be used for cash withdrawal but you can only open one basic account. In contrast, you can open as many general accounts as you like but they can't be used for cash withdrawal. Depending on regional interpretation of regulation, in some districts it is obligatory to make payroll payments from the basic account, while in others it is allowed from either account.

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