Korean Air: Cross-border FX Outsourcing for Proficient Management of Surplus Cash
Your company has cash-generative operations in several countries whose regulators are at the more lenient end of the spectrum. You run a centralised treasury and your debt is mainly at holding company level – so you like to bring surplus funds back to the centre as quickly as possible. You would like to automate this cross-border flow of funds on a daily or weekly basis to reduce transaction fees and remove administrative work. Simple: use cross-border sweeps, right? Hold on – your company invoices in local currency in each of the markets and therefore receives sales proceeds in local currency. But the central treasury base currency (as well as all the holding company debt) is in a different currency. Herein lies the problem.
Cross-border sweeping or cash concentration in a single currency (usually US dollars in Asia where more than two countries are concerned) is a concept which is not new. The most common form is a two-layer structure, where surplus funds from multiple legal entities within a single country are concentrated into a master account; the master accounts within each country then sweep cross-border on a regular basis into a central treasury account usually in the multinational corporation’s (MNC) country of domicile
This structure is applicable where there is a single base currency, so a French company can operate domestic euro cash pools in Belgium, Italy, Germany and Spain, sweeping surpluses in euro back to Paris to pay down debt or invest. The structure can also be applied where MNCs have only two or three dominant currencies. Central treasuries will often maintain, for example, a USD and a euro pool, either in the country where the head office is located, or owned by the central treasury but operated in remote locations. The location of the accounts is naturally dependent on the purpose to which the surplus funds will be applied.
Taking it to the next level, operating an in-house bank solves the problem of managing receivables in multiple currencies by utilising a central entity to net off all payments on a daily basis. The central entity operates an account in each of the operating currencies and manages the end-of-day balances across the different currencies by entering the market. The main drawback with this structure is that it tends to be resource-heavy. For example, a major British energy company runs a dealing room of 15 traders simply to handle the daily currency exposures created by its in-house bank. Furthermore, despite the clear benefits, an in-house bank brings a level of complication and maintenance demands, which are sometimes beyond the reach of MNCs.
So, to support a centralised treasury policy where sales receipts are largely in local currency arising in many countries worldwide with a level of automation and cost-saving, a cross-border foreign exchange (FX) outsourcing solution is the obvious answer. The concept is a straightforward one: simply adding an exchange element to a standard cross-border sweep. For each currency pair, the margin to be applied is agreed prior to implementation, and target or pegged balancing tends to be the most appropriate sweep in most cases. Specific legal agreements are required to authorise the bank to apply the FX conversion and settlement on the company’s behalf, and tax issues need to be addressed before the structure is agreed.
Levels of sophistication and tailoring can be introduced, depending on the company’s requirements. For example, particularly relevant in an Asian context is the use of a regional treasury centre. This consists of a two-tier model: sweeping local currency funds from Asian markets into a single country (usually Singapore or the Hong Kong Special Administrative Region) before applying the margin agreed. As more and more MNCs operate multiple bank accounts within a large number of countries, and central treasuries become leaner and look for ever-greater cost savings, the demands for outsourcing solutions will grow – and MNCs are increasingly asking banks to take care of non-convertible currencies on their behalf, as well as handling sales receivables in countries with less stringent regulatory régimes.
Korean Air, the world’s second largest air cargo operator, generates nearly $1bn in post-cost surplus cash annually from its five main operating areas: North America, Europe, Japan, China and the rest of Asia. Treasury policy is centralised, with the control of all collection accounts worldwide residing in Seoul. As is the case with many airlines, much of the significant costs and debt for aircraft financing is located centrally in Seoul. Therefore the speedy and efficient centralisation of surplus cash is of vital importance.
The initial focus was narrowed from Europe, China and Asia Pacific, to just Asia Pacific in the interests of time. Other than in exceptional cases such as Indonesia, where all billing is done in USD, Korean Air’s passenger ticket sales and cargo receipts are all in local currency. Korean Air had many bank relationships in Asia Pacific, usually more than one per country, and surplus funds tended to be remitted back to Seoul on a weekly, bi-weekly or monthly basis, depending on the timing that an informal peg balance was reached. The conundrum therefore was three-fold: how to speed up the centralisation of funds, converting the local currency receivables into USD; how to increase central control over in-country collection accounts; and, how to remove the administrative burden of TT initiation.
HSBC designed a solution for Korean Air in Asia Pacific which revolved around the debit of local currency in-country and the credit of USD to Seoul on the same day. Given the size of cash surpluses generated by Korean Air, the transfer of funds was implemented on a daily basis. In this way, the centralisation of Australian, Hong Kong, New Zealand and Singaporean dollars could be achieved at least seven days earlier than under Korean Air’s previous arrangements. In addition, the administrative headache of having to initiate transactions on a regular basis was removed, plus the solution is scalable to include other areas within the FX-outsourced structure, which was a key Korean Air requirement.
Having taken the decision in early 2004 that a significant depth of change in cash management policy was required to meet the goals envisaged, the final structure implemented realised a number and variety of tangible benefits – both expected and unexpected:
With reference to the Korean Air experience, the following are considerations to be taken into account when FX outsourcing.
The regulatory environment is always first on the list of potential barriers when considering any liquidity management solution. The key for FX outsourcing is that both the absence of exchange controls and permission to sweep funds cross-border are absolute prerequisites. With regard to the former, any documentary requirement for the remittance of local currency outside its country of origin is a showstopper. For the latter, the automated sweep of local currency outside its home market and into USD (or another base currency) is akin to a traditional cross-border sweep and therefore is subject to the same regulations.
With cash concentration (cross-border or otherwise), the physical transfer of funds between the group entities of an MNC always raises questions. Tax considerations are foremost – inter-company lending leads to potential withholding tax liabilities, arm’s length interest payments, transfer pricing issues, etc. In Korean Air’s case, these issues were minimised due to a simple fact: all in-country offices are branches of the same legal entity: Korean Airlines Co. Ltd. This brought two major advantages for HSBC’s recommendations on a liquidity management structure: first, withholding tax and inter-company lending issues were minimised; second, the ability to transfer funds automatically was improved. So, for example, in China, all sales proceeds can be remitted outside the country as long as sales lists and tax certificates are provided.
Again, another common obstacle when considering complex cash management structures, which involve wholesale changes in the way companies operate treasury policies and systems, is the level of acceptance within the company itself. By its nature, cross-border FX outsourcing involves many countries and therefore requires not just the agreement of the country managers but their active buy-in and support for the wider group benefits.
There are many other cases where an FX outsourcing solution will be applicable and beneficial to MNCs. The transport industry is an obvious candidate: many companies are developing more centralised treasury structures; operations tend to be very local; and legal structures (particularly in the case of airlines) tend to be conducive to FX outsourcing. Furthermore, the big transport industry centres tend to be in countries and regions where the regulatory regimes are open to cross-border sweeping and tend not to impose exchange controls: i.e. Hong Kong, Singapore, the UK, the EU and the US.
In many other cases though, a lot of the restrictions are too difficult to overcome. The issues raised by inter-company exposures are significant; withholding tax liabilities are many; and the change to decision-making policies within companies is large. However, the combined effects of market deregulation, MNCs’ global expansion and the ever-increasing desire of treasury policy to centralise and realise more cost savings mean that cross-border FX outsourcing will become a more widespread solution particularly in Asia.