Banks Turn to China for Supply Chain Financing

There are a number of strong regional banks in the US, the European Union and Australia whose strategy revolves around being a comprehensive provider of banking products and services to corporate clients in their home markets. But, as these companies seek to become more globally competitive, they are constantly looking to expand their markets and achieve cost efficiencies by shifting sourcing to low-cost manufacturing bases. A market that accounts for the most significant contribution to this shift is China. It is not only one of the biggest and fastest growing markets for companies in the developed world, but also one of the most cost-effective sources of supply.

This has resulted in rapid growth in trade in the last decade between China and companies from countries in the Organisation for Economic Co-operation and Development (OECD).

This trend has implications for regional banks in developed markets (OECD banks) in terms of their ability to provide full trade services for their corporate clients. They need to develop a good understanding of China to be able to cover their clients’ trade with companies there. This involves providing risk protection, arranging for finance at both ends of the transaction, and generally facilitating efficient trade.

OECD Banks and Companies Used to Benefit from Letters of Credit

The challenge for OECD banks with no presence in China would not have seemed so insurmountable in the era when most international trade was conducted using letters of credit (LCs). By entering into correspondent banking tie-ups with Chinese banks, OECD banks could mitigate a lot of the risks of trading with Chinese companies. LCs enabled the OECD banks to extend their trade offerings to cover both sides of their clients’ trade with China.

For exports, the OECD banks could use the LC from the buyer’s bank in China (with their own confirmation) to not only protect their customer against buyer risk but also provide efficient financing and settlement of their export transactions. Similarly, for their clients’ imports from China, the OECD banks could open LCs to not only ensure a degree of certainty that the right goods were being shipped, but also enable their Chinese correspondent banks to provide financing support for suppliers.

But, because of the extra costs, the increasing influence of buyers and the manpower-intensive nature, the luxury of an LC is fast disappearing, as Figure 2 indicates.

OECD Banks May Need Partnerships With Supply Chain Finance Providers

In an environment where the comfort of a LC can no longer be assumed, it will become imperative for OECD banks to forge supply chain financing partnerships with banks that have a physical presence in China. These relationships will have to be far deeper than mere correspondent banking. In the absence of such partnerships, OECD banks will find it difficult to protect their clients’ business in their home markets against banks that are more global and that have a presence across the OECD and emerging markets.

A New Approach to Supply Chain Finance

Supply chain financing is the response to an emerging need for banks to play a more active role in the activities of a company’s suppliers and buyers. This need was a direct outcome of the changes that companies had begun to implement as a part of their supply chain management initiatives. Some of the factors behind such changes are explained below.

Increased outsourcing

Companies have increasingly begun to outsource many parts of their manufacturing and distribution activities to external members of their supply chain. This means that their suppliers now manufacture more and therefore hold more work in progress and finished goods inventory than before, a large part of which the company would have been holding on its balance sheet before outsourcing.

Similarly, they try to push finished goods to their distributors and stockists as soon as possible, so that goods can be held closer to the consumer. This again means that the company’s distributors hold more stock than the company itself. What all this means is that a significant portion of the company’s erstwhile working capital financing needs have been pushed on to the balance sheets of their suppliers and distributors.

Financing constraints

The suppliers and buyers are usually of much smaller size than the company itself and their ability to raise competitive financing on their own is limited. The additional working capital needs created by the increased outsourcing discussed above only exacerbate this problem. This adversely affects the company in that suppliers will find it difficult to offer the company the credit terms they need, and distributors will find it difficult to buy and stock more products unless the company is willing to extend greater credit terms.

Increased financing costs

A direct consequence of the factors above is that when suppliers and buyers borrow locally on the strength of their own balance sheets, the price they pay for this financing is a lot higher than it would be for the company. In the case of suppliers, this means the higher cost of financing is passed onto the company, thereby increasing the cost of goods. In the case of distributors, this means that their margin on the company’s products is reduced.

Increasing credit exposure

The factors above mean that the only way companies can increase sales through their distribution channel is by giving trade credit. Increasing sales by increasing the credit period has the obvious ill effect of increasing trade debtors on the company’s balance sheet and therefore making the balance sheet riskier.

Why Supply Chain Financing is Different

Supply chain financing is a relatively new concept in the banking industry, where a bank examines the company’s supply chain and provides finance to key suppliers and distributors (collectively referred to as ‘channel partners’) for their sales to the company and their purchases from the company, as the case may be.

Supply chain financing differs from traditional bank financing in two significant ways. First, the bank involved does not evaluate the individual channel partners to whom it is providing finance on a stand-alone basis. Rather it evaluates the company in terms of its financial strength and market position, and, more importantly, the effectiveness of its supply chain management practices. If there is demonstrable ‘stickiness’ in the company’s supply chain, the bank would set up facilities for the channel partners without any significant financial assessment of the individual links in the chain. Individual partners are assessed only to establish their position and importance in the overall supply chain and their past trading history with the company.

Secondly, financing is provided only for that portion of the channel partners’ business that has a direct transactional link with the corporate customer. Below is an evaluation of three possible options available to OECD banks to enter into partnerships with banks that have strong supply chain financing capabilities and a local presence in China.

Option 1: Supplier Finance Partnerships

Under its supplier finance programme, Standard Chartered offers packaged pre- and post-shipment finance to eligible suppliers of the OECD banks’ clients. Standard Chartered works closely with the OECD bank to understand and evaluate their clients’ procurement and supplier management policies. Individual suppliers will be assessed within the context of the company’s supply chain, based on which facilities will be set up for the suppliers. This finance is provided for those parts of the suppliers’ transactions that have a direct link to the company, and is based in large part on the strength of the underlying relationship.

The suppliers can be financed under this product in two ways: pre-shipment and post-shipment.

The bank provides pre-shipment financing to a strategic supplier who is the recipient of a purchase order or an LC from its corporate client. The supplier would be given a pre-shipment loan of up to a fixed percentage of the value of the purchase order. Once the supplier has shipped the goods and submitted the invoice, along with evidence of transport to the bank, the pre-shipment loan would be automatically converted to a post-shipment advance. Payment for the invoice would be made directly on the due date to extinguish the post-shipment loan.

For suppliers who do not qualify for pre-shipment finance based on the bank’s assessment of their importance in the company’s supply chain, the bank will only provide post-shipment finance. The bank provides post-shipment finance to the supplier after the supplier has shipped goods to the client. The post-shipment finance is liquidated on the due date from the payment received by the bank from its corporate client directly for the invoice.

Option 2: Import Factoring Partnerships

Factoring is a complete working capital solution that has four main elements: financing, credit risk protection, sales ledger management and collection services.

The OECD exporter and its bank, the OECD bank (called the export factor), enter into an agreement under which the factor buys the clients’ trade receivables, usually without recourse, and assumes responsibility for the buyer’s financial ability to pay.

In cases where the buyer is in China (and most other Asian countries), the OECD bank can enter into an arrangement with an import factor in Asia, such as Standard Chartered. Under such an arrangement, the OECD bank would enter into an inter-factor agreement with Standard Chartered (called the import factor), and in turn assign the receivables to the import factor.

The import factor would then carry out a credit investigation on the buyer (if the buyer had not already been researched by the import factor) and establish credit limits.

Once the seller dispatches goods and invoices to the buyer, it would submit details of the invoices to the export factor, which would then forward it to the import factor. The export factor at this stage may advance up to 90% of the invoice value to the seller. The import factor can also do the financing in cases where the export factor so chooses.

The import factor collects the debts from the buyer on behalf of the export factor and remits proceeds to the export factor.

If the buyer goes bankrupt or is unable to pay its debts for credit reasons, the import factor would pay the export factor 100% of the debts. The export factor passes on this money to the seller after settling any outstanding matters.

Option 3: Silent Payment Guarantees

There are a lot of instances where exporters in OECD markets receive large orders from Chinese or other Asian buyers about whom they do not have much knowledge concerning credit-worthiness. The exporters require some reassurance that once they ship the goods, they will get paid. That is, they need assurance against insolvency – of the buyer and the country – before they undertake any work.

With LCs, the exporter is protected against buyer insolvency and, by adding confirmation to the LC, the OECD bank can provide protection against the Chinese bank and country risk. But this is not possible with open accounts.

Silent payment guarantee is a possible solution. Here, the OECD bank can tie in with a financially strong partner with a large presence in China or Asia to provide silent payment guarantees in favour of the OECD bank’s exporter clients. This guarantee will be issued without the express knowledge or consent of the Asian buyer and will cover the exporter against buyer insolvency and country risk.