RISK MANAGEMENT
Multinational Companies in China: Managing Receivables Risk
April 5, 2007
David Leong, Standard Chartered Bank

Issues with Domestic Sales in China

The growth of the domestic economy in China presents a tremendous opportunity for multinational companies (MNCs). For many of them, China has either already become a very important market or represents a very significant pool of potential buyers. While selling in China may be a phenomenal opportunity, it is matched with challenges on a number of fronts, including the need to finance these sales.

To capture market share in China, many MNCs have offered credit terms of 60 to 180 days to customers, well beyond normal practice in other markets. This raises significant issues linked to risk management. Many MNCs adopt a distributor sales channel in China to grow their sales and presence. In a large country such as China, it is typical for multinationals to have up to 1,000 distributors. As the demand for the MNC's products grows, the distributors' requirements for working capital will increase. This creates a bottleneck if multinationals are unwilling to go beyond their normal credit terms for the distributors, resulting in potentially foregoing extra sales.

So what are leading MNCs doing to stay ahead of their competitors while mitigating or controlling their accounts receivables payment risk? This article looks at ways in which multinationals are working with financial intermediaries and at solutions for managing this risk in the Chinese market.

Bank and Commercial Drafts

The most common method of managing such risk in China is to use a bank-accepted draft (BAD). A BAD is a domestic draft instrument that is guaranteed by Chinese banks and issued by buyers to sellers as a guarantee of payment for goods delivered.

BADs offer buyer and seller an intermediate solution in terms of financial and risk management. The issuer of the draft (the buyer) gets to extend his payment terms to the supplier for up to 180 days while the beneficiary of the draft (the seller) is able to obtain a guaranteed payment, albeit a Chinese bank guarantee. At the same time, the seller has the option of the following:

• Discounting the draft (with or without recourse)

• Transferring the draft on to the next supplier down his value chain

• Waiting for the payment on maturity date from the issuing bank

The cost of issuing a BAD for a buyer is also relatively low at a regulated flat rate of 0.05% of the draft value. However, most companies would need to pledge securities such as cash collateral to obtain such facilities. For the seller, the cost of discounting the draft is also regulated in China at a current minimum rate of 3.24% a year. The cost can escalate if the discounting bank deems the issuing bank is of high or higher risk.

Many MNCs are now discounting the BADs they receive from local buyers with foreign banks such as Standard Chartered, as foreign banks are able to offer the discounting facility on a without-recourse basis to the MNC. This allows the MNC to enjoy the benefit of improving its days sales outstanding and financial performance measurements.

Bank-accepted Drafts in Brief

• Buyer of goods issues BAD to seller

• The BAD is duly accepted by the buyer's bank - the accepting bank, issuing bank or acceptor

• The maximum payment period allowed is up to 180 days

• The seller (of the underlying transaction) is the beneficiary or payee of the BAD, and possibly discounting applicant of the BAD

• Usually non-recourse for better balance sheet management by MNC

• Minimum cost of discounting rate of 3.24% a year is allowed

Less commonly used is the commercial accepted draft (CAD). Unlike the BAD, the CAD only offers the seller a guaranteed payment from the buyer itself. There is no bank guarantee on the CAD and the supplier has to undertake the payment risk of the CAD issuer or acceptor. However, it is now common for MNCs and large Chinese companies to work with their main banks to provide CAD discounting facilities to their suppliers for drafts issued by them.

The benefit of CAD discounting is that it allows buyers to stretch their payable period to up to 180 days. The instrument also allows the parties to obtain working capital from the bank at a regulated 3.24% a year minimum, which is lower than the minimum cash loan rate of 90% of the People's Bank of China (PBOC), currently at 5.4% p.a. for 180 days tenors and below. Subject to the buyer risk, many foreign banks now offer, on a without-recourse basis, discounting CAD facilities in China for sales to acceptable large companies.

Open Account Trade Terms and the Emergence of Domestic Credit Insurance

The growing sophistication of the Chinese buyer market and the tightening of the Chinese lending market have resulted in a need to move away from BADs towards open account trade instead. This trend has provided a new challenge to many MNCs in China, hence we have seen the recent development of the domestic credit insurance market. Among companies offering such insurance are Ping An (with Coface), Sinosure, AIG and Allianz.

Domestic credit insurance has allowed MNCs to offer open account terms to their distributors and large Chinese buyers. So far, credit insurance companies have offered this solution mainly to MNCs because of their tight credit control, monitoring standards and procedures. It is estimated that the cost of insurance premiums range from a flat rate of 0.25% to 0.60% depending on volume, turnover and risk assessment.

Banks have started packaging without-recourse or limited-recourse receivables purchase facilities for insured MNCs. The minimum cost of financing offered by the banks is regulated at 90% of the prevailing PBOC rate. This works out at about 4.68% a year at current PBOC short-term rates. It is also possible to package the solution with a commercial draft discounting structure, which then allows the bank to offer the discount at the draft discounting regulated rates of 3.24% a year as a minimum.

Distributor or Dealer Financing Programmes

As consumer demand in the domestic market grows dramatically in China, the distributors or dealers of major multinationals face ever-increasing pressure on their working capital requirements. The situation is not made easier by the tight lending policy of local Chinese banks to the small and medium-size enterprise (SME) sector of the market.

A similar trend has been seen in markets such as India and Thailand, where there is also a high dependency on domestic distributors to reach out to the retail market. In such markets, mature distributor or dealer financing programmes have been developed. In China, the emergence of such programmes is at an infancy stage. Standard Chartered is believed to be the first foreign bank to offer such a structured and customised programme for selected MNCs.

Some local Chinese banks are offering solutions based on inventory-holding financing for the distributors of large MNCs. The distributor or dealer programmes are working capital financing solutions offered by banks to selected strategic distributors or dealers of MNCs and large companies. By adopting a parameter-driven supply chain evaluation framework, the bank may offer distributors short-term facilities to buy goods from the MNC (often referred to as the 'anchor'). Such programmes provide tremendous benefits to the MNCs as they are able to work with a financial institution to take up most of their key distributors' credit risk while extending longer credit terms or even open account terms.

The key parameters of such programmes are:

• High dependency on the MNC, usually 40% or more of turnover should be derived from the anchor's product

• At least two years' satisfactory trading history with the anchor

• Must be strategic and recommended by the anchor

• No material overdues to the anchor beyond 30 to 90 days

The anchor would normally also provide comfort or weight to the lending by providing the following assurances to the bank:

• Stopping supply to the distributor should it default on the bank's loans beyond certain pre-agreed periods

• Immediate notification to the bank should it decide to end its distributorship contract with the borrower

• Providing risk-sharing of any potential loss resulting from the default of the loan by the distributor

For MNCs, there are the following significant benefits:

• Risk reduction as sales to distributors increase

• Increase market share quickly over competitors

• Ability to enhance distributor loyalty by arranging access to bank financing to support working capital needs

• Enhance dealer stability and use bank for credit assessment of distributor risk profile

• Outsource collection of accounts receivable to the bank

For the distributor, the benefits can be summarised as:

• Access to financing from a financial institution. This is even more important in China, where it is estimated that 70% of SMEs do not receive sufficient funding from banks. This has resulted in many such companies borrowing from the 'black market' at rates of 20% a year or more.

• Access to lower cost of financing as most of such programmes range from 6.75% to 9% a year, depending on the risk profile of the distributor and risk sharing ratio with the anchor.

• Stability in cash flow projections and financial forecasting as the source of funding is now secure.

There are several challenges in running such programmes in an emerging market like China. Some of the challenges that Standard Chartered has faced include:

• Financial transparency of the distributors is not high. It is common for such distributors not to audit their financials as this is not required under Chinese regulations. Secondly, it is very common for Chinese companies to close down and start up another one to take advantage of lower taxes.

• The distributor selection and monitoring criteria, as well as trading history of the MNC, thus becomes even more important as this will provide a valuable evaluation insight into the payment integrity of the distributor.

• The management and shareholder quality of the distributor must be assessed carefully by the bank. This can be another major challenge as it is difficult to obtain full transparent information on the main stakeholders. Personal guarantees and bankruptcy are also not yet enforceable in China.

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