China’s Liquidity Management Environment

While China’s economy might be progressing rapidly, treasury management in the third-largest trading nation remains bound by strict regulations on foreign companies, foreign banks and foreign exchange.

China managed a staggering average gross domestic product growth of 9.4% between 1978 and 2004. Its foreign direct investment was valued at US$60.6bn in 2004 and total trade has been growing at 31% year-on-year since 2000, amounting to some US$1.15trillion in 2004.

Foreign companies are responsible for more than half of Chinese exports yet treasurers must manage their company’s significant financial resources within very tight constraints. The good news is that their task has not been complicated by a choice of options.

China’s Banking Sector

Four large state banks dominate China’s banking sector: Bank of China, Industrial and Commercial Bank of China, China Construction Bank and the Agricultural Bank of China. Dubbed the ‘big four’, they issue about two-thirds of all loans and hold over two-thirds of all deposits. The balance of the business is shared among more than 10,000 financial institutions, namely policy banks, joint-stock banks, regional banks, rural credit cooperatives and foreign banks. There are more than 60 foreign banks, with almost 200 branches and about the same number of representative offices, and seven joint-venture banks, which in total issued an estimated 3% of total assets and deposits as of mid-July 2004. Foreign bank market share accounts for less than 5% as of mid-November 2004.

As a result of the severe limitations on the establishment and expansion of foreign banks and on the range of RMB transactions that they can execute, local banks offer wider networks as well as superior renminbi (RMB) capabilities. However, the strong internal controls of foreign banks have resulted in better credit ratings compared with those of the big four. Foreign companies may also find foreign banks easier to do business with as they present a more familiar degree of professionalism coupled with strong capabilities, especially in the area of cross-border services.

Within China, foreign banks can offer virtually one-stop banking, giving treasurers a single point of contact while the bank handles myriad relationships with various branches of its local bank partners. On the other hand, as a result of the local banking culture, a treasurer banking directly with a local bank might have to deal with many provincial or city branches on a regular basis.

Given the restrictions on foreign banks, in terms of client segments and geographic areas, it is important that treasurers considering a foreign bank choose one that has strong alliances with at least one local bank. This will greatly enlarge the banking network and thus ease both payables and receivables. The nationwide clearing system (the Modern Payment System) is improving although local banks were at first reluctant to participate, given their heavy investments in proprietary clearing systems. Most foreign banks participate as direct clearing members for RMB, US dollar (USD) and Hong Kong dollar currency transactions, although membership is on a city, rather than national, basis.

An alternate payment and collection channel is through the clearing infrastructure of the China Post Office (CPO) saving banks. The CPO network is more comprehensive than those of the big four banks. Banking regulations permit few variations in account structure and impose strong controls on both RMB and foreign currency (FCY) transactions. Interest rates are regulated, although recent changes have removed the upper and lower caps of loan and deposit rates, respectively.

Foreign companies may hold only limited types of RMB account: basic and general. The RMB is a restricted currency and no offshore remittance is allowed. FCY conversions to RMB are limited to a specific amount per day and, unless trade related, must be approved by the State Administration of Foreign Exchange (SAFE).

Foreign companies may have only three main types of FCY accounts: capital, loan and settlement. FCY accounts are under the umbrella of the SAFE and both capital and settlement accounts are established with designated ceilings. When balances rise up to these ceilings, they must be either converted to RMB or remitted offshore.

Few Options for Liquidity

The treasury environment for foreign companies offers little in the way of options to enhance liquidity. The following is a discussion of the current situations with respect to funding, yield enhancement, funds repatriation and hedging against RMB appreciation.

The first challenge for treasurers is getting capital into China. While foreign banks are free to operate with any entity, banks can only open FCY accounts on behalf of clients with the approval of the local SAFE office.

Ongoing funding needs may be satisfied domestically by one of five methods: shareholder loan, back-to-back guaranteed loan, bank loan, inter-company entrust loan and working capital financing.

Foreign companies can secure additional funds by having the overseas parent company inject a shareholder loan, which is then lent to the foreign company in China with a defined repayment schedule. However, value-added tax must be paid before interest and the foreign company must get the approval of SAFE to withdraw funds.

Alternatively, foreign companies can secure back-to-back loans from international banks on the basis of an offshore balance and a corresponding corporate guarantee. Since April 2005, companies must register the foreign guarantee with SAFE, thus making it an integral part of the solution.

This registration allows the bank to make a claim overseas should the foreign company default. SAFE also requires that the loan amount be justified by the gap between the approved investment and the registered capital.

Non-guaranteed RMB loans are available from local and foreign banks. There is little variation in lending rates as the upper limit of loan rates is set by the central bank, the People’s Bank of China (PBOC); it has removed the lower limit. Banks can generally offer a discount of up to 10% off the base rate.

Inter-company loans are facilitated in China through an entrust structure. In the absence of cash concentration solutions, companies can transfer working capital from one inter-related company to another through a one-to-one RMB entrust loan. This allows a company to access RMB funds available in another part of its operation, instead of having to inject more FCY into China. Companies can also use this mechanism for USD entrust loans within China.

A multi-party entrust loan adopts the entrust loan regulatory framework and combines it with the capabilities of a zero-balancing account mechanism to create entrust loans between the master entity and each participating entity on a daily basis. A negative aspect of this is that, as with any entrust loan, interest earned is subject to a business tax and the loan amount is subject to a stamp duty.

Companies that have accumulated capital may use their funds for expansion. In general, domestic trade arrangements do not use letters of credit, as they are not governed by UCP5004, the international code. In place of letters of credit, companies tend to use RMB-denominated drafts for inter-company settlement. Drafts are commonly future-dated and may be either bank-accepted drafts (BAD) or commercially accepted drafts (CAD).

Banks may offer draft discounting, which can lower RMB funding costs substantially. Companies can discount their receivables using BAD discounting or discount their payables using CAD discounting. BAD discounting may yield up to 150 basis points saving on RMB funding costs.

Yield Enhancement

The challenge for treasurers with excess capital is how to enhance it. This is easier said than done in China because deposit and loan interest rates are governed by the PBOC leaving treasurers with only fixed deposits, treasury bills, corporate bonds and entrust loans with which to maximise their treasury resources.

Fixed deposits are available in both RMB and FCY accounts although, given the ceilings imposed by the SAFE on FCY accounts, companies are unlikely to hold significant FCY fixed deposits. RMB fixed deposit rates are set by the PBOC while FCY rates are set by the SAFE; tenors range from overnight to five years.

T-bills are issued in RMB by the government but can only be purchased through local banks. The tenors range from three months to two years.

Corporate bonds, which are generally rated by the central bank, are also available but may not hold the risk rating required by treasurers. Other financial instruments such as derivatives and liquidity funds are not widely available, leaving fixed deposits as the only viable option for treasurers.

Some banks can provide enhanced yields through third-party RMB entrust loans, basically bridging loans between lenders and borrowers. The entrust loan act requires that different banks act on behalf of the borrower and the lender. The lending bank acts as the guarantor and shares the liquidity pool with companies who have fund-raising requirements. Lenders can benefit from this arrangement through somewhat higher rates than fixed deposits.

Funds Repatriation

Treasurers can repatriate funds in one of three ways: issuance of dividends, a transfer pricing mechanism and through cross-border FCY entrust loans. Since the RMB is non-convertible, funds are repatriated only in FCY. For some companies, royalties may be another way of repatriating funds.

While repatriating funds through dividends is the standard method, it invokes high taxes, as most countries do not have double taxation treaties with China. This situation is unlikely to change in the short term.

Transfer pricing is a much more interesting tool for repatriating funds. Many foreign companies establish separate trading companies in China that purchase goods from interrelated companies overseas. This allows money to be transferred out of China within a business context, rather than a banking context. Where feasible, the trading company should be established in a special economic zone so that the foreign company can also reduce any custom duties and taxes on the imported goods.

Transfer pricing is the responsibility of the State Administration of Taxation, which issues transfer-pricing audit guidelines to the local tax authorities. As long as the transfer price is set at an arm’s length, these arrangements do not generally attract undue interest from the financial authorities.

Theoretically a cash pooling concept, a cross-border entrust loan between a foreign company and its offshore office, is possible for qualified foreign-invested enterprises (FIE). The FIE must open a special loan account to consolidate the funds for a cross-border entrust loan and issue a corporate guarantee to ensure that the principle will be returned in due course.

The application of the cross-border entrust loan remains narrow as it is difficult for a foreign company to accumulate enough dollars, what with SAFE ceilings on FCY accounts and the difficulty in obtaining SAFE approval to combine accounts into a single bank. These barriers, coupled with the maximum of a two-year tenor before repatriation of funds to China, means that the cross-border entrust loan does not solve the problem of repatriating funds over the longer term.

Hedging Against RMB Appreciation

Standard forward contracts are available from local banks, which can quote a forward contract rate of up to one year. While foreign banks are not allowed to offer RMB forward contracts, some foreign banks have partner banks that can offer the product. When there is a negative interest rate carry between the RMB interest rate and the FCY interest rate, treasurers hedge the negative carry offshore through offshore non-deliverable forward contracts.

Summary

China remains an attractive market despite the challenges facing treasurers in bringing money into the country, domestic transactions and repatriating funds. Most of the challenges are regulatory, and while these regulations cannot be expected to disappear overnight, there will be some changes brought upon China’s full accession to the World Trade Organization. Foreign banks are expected to benefit by early 2007, when they should be permitted to offer RMB services anywhere within the country.

However, this opening up will not result in China’s banking system gaining the same efficiencies as banks in other countries without other major changes in economic and social structures. In the meantime, treasurers should watch carefully for regulatory shifts, which may offer new tactics for liquidity enhancement, and enjoy the challenge of working in the world’s most dynamic economy.