Working Within the Limitations of China’s Credit Culture

‘What to do with China?’ A simple question to a complex problem faced by Mark, the regional CFO of a Fortune 50 company ramping up operations in China. A question faced by many before. And a question that resonates in the minds of many executives today.

Five thousand years of turbulent Chinese history have created a strong culture that has historically resisted external change. As such, it is a daunting challenge to effectively import western practice into the Chinese market. It is not uncommon to hear the phrase ‘you don’t understand China’ or ‘it is different here’. The temptation to alter your core business model to meet the Chinese market is often strong. However it is rarely necessary.

China is not a homogenous market. It is a country which unites a diverse range of languages and cultures. Defining a strategy for China is akin to defining a single strategy for Europe. Language, cultural, legal, regulatory and infrastructure challenges make local knowledge or experience imperative to navigate effectively. The market dynamics are such that change is a constant and assumptions should be revalidated regularly. To paraphrase Albert Einstein, ‘while you need to ask the same questions, the answers may be different this time.’

Credit is not a concept well understood in China. Through various periods of Chinese history, the Chinese people have found it necessary to minimize official knowledge of wealth. As such, it is not uncommon for individuals to have large cash holdings at home or to transact in cash commercially. As such, China has come to be known as a cash economy. Settlement between banks has been largely paper-based and cumbersome, which further exacerbates the role of the cash economy.

The political agenda also plays an important part in credit understanding and behaviour. State-owned enterprises (SOEs) are the backbone of the Chinese economy. Under communism, every Chinese worker was guaranteed a job and income from SOEs. Hence they are critical in the provision of employment for the populace and consequentially, the stability of the government.

In 1978 under Deng Xiao Ping, China embarked on its journey to a free market economy. In the 1980s, the state began to move the responsibility of the funding for SOEs to the banks. The banks lent billions to the SOEs. These loans were looked upon in the same way as money from the government, a free source of cash with no repayment required. As the SOEs continued to burn through cash, repayment schedules continued to blow out to the point where the banks were left with a massive portfolio of non performing loans (NPLs).

Over the past years, the government has and continues to make massive cash investments to sure up the balance sheets of the banks. But the underlying structural reform has been lagging. Jobs are still critical to the stability of the government and the flow of funds to SOEs continues. Reform is underway, but by the nature of the change required, the process is slow and ongoing. 2001 saw the first significant change with the People’s Bank of China introducing the “Measure on Bank Credit Registration and Information Management (Trial)”. The purpose of this was to create a national system for measuring and beginning to manage credit risk.

At the corporate level, business has largely operated on a cash basis. The only credit given was usually one where guanxi, or close mutual relationship, existed. With the influx of western money and business, credit has been forced upon the Chinese market. Early market entrants freely granted 30 day standard credit to drive sales, only to realize significant losses in bad debt and aged debtors.

Poor credit management in China often disguises poor working capital or execution management. The poor market controls around credit, often exacerbated in the quest to drive growth, have perpetuated the historical weakness of many of the SOEs.

Chinese business is growing rapidly. Growth rates are significantly above world averages. High growth rates are appealing to investors, but they have associated risks. In this example, the Chinese carriers have significantly greater growth than their global peers (Ryanair is an exception).

Operationally, Chinese companies are significantly lagging in working capital reform. In this example, global airlines have managed their cash conversion cycles with increasing discipline. In high growth, each foreign airline increases free cashflow. Chinese airlines require more capital. Hence for every $100m in revenue growth, China Eastern requires $11m (11 per cent) in additional capital. Income is 0.66 per cent.

The result is a rapidly increasing debt position. Higher leverage leads to poor interest coverage and then to higher cost of debt. These negative cycle effects are typical of high growth companies and often can be fatal. While aviation can be an extreme example, this same pattern is emerging in China across many industries and enterprises.

As a result of poor working capital management, this increasing debt position highlights the escalating credit risk that many companies are exposed to. So when Mark was assessing structuring his financial operations in China, he was confronted with a number of conflicting pressures and challenges.

Conventional wisdom in the market suggested he would be in a tough spot. Working capital requirements would be significant and credit risks would be great. The sales force insisted long credit terms were standard and a minimum requirement to do business in China. Against this backdrop, Mark went into the market and began to appreciate what most consumers intuitively understand about China. China is a cash market. And operating on a cash basis lowers pricing. So Mark went to market with a cash-centric strategy.

Despite the many barriers, the business Mark helped create in China became the company’s worldwide leader in working capital management. The business itself has grown to be incredibly successful and cash rich. The challenge for the business today is how to use the incredible liquidity created by the China business within global operations, but that is another story. The insight and execution of Mark, his team and advisors, paid dividends which placed the company in a prime position within the Chinese market.

Mark’s story is not unique. The key to success in China is, as in any market, understanding what is core and context within your business. Changing anything that is core to the success of your business places your business at risk. Acknowledging the challenges and sensitivities of a local market is critical in tailoring the context of delivery and execution in that market. As in Mark’s case, he was able to take a market weakness and develop it into a competitive strength.

China is not a market you need to tiptoe about and stumble on cultural sensitivity. Good business practice is good business practice. And there is a hunger in China to be the best. The Chinese have a saying, pronounced “Kai men jian shan”. It means open the door and see the mountain, meaning “be direct or get to the point.” The faster you can adapt the context of your business to market and work within the limitations to achieve what is critical for your business, the better. Don’t assume the market limitations are limiting.

As the manufacturing engine for the world economy, credit is playing an increasingly important role in China. Understanding the limitations and how to operate effectively within those parameters is clearly the challenge. There is no substitute for spending time in market and leveraging the experience and advice of core partners in market.