Working Capital in Asia: Challenges and Trends
Working capital is a precious commodity at any time, but especially in an adverse business climate. The current uncertain global economic outlook, coupled with the parlous state of many bank balance sheets, constitutes just such a scenario. While Asia has itself fared considerably better than the US and Europe, its extensive trading links with those regions have had a predictable knock-on effect.
In such an environment, pruning working capital requirements to the absolute minimum has become a greater priority than ever for corporate treasurers in Asia and elsewhere. This was borne out at a recent meeting of senior Asian treasury personnel in Hong Kong, where attendees discussed some of the techniques they are considering and using to optimise their corporations’ working capital and the obstacles they faced when doing so.
While trapped cash is often a discussion topic whenever Asian treasurers meet, the current environment has created a new working capital problem for some Asian treasurers, possibly best described as ‘trapped sourcing’. China’s attraction as a highly cost-efficient sourcing location needs little introduction. Unfortunately, the recent strength of the Chinese renminbi (RMB) versus US dollar (US$) coupled with the high costs of hedging RMB/US$ exposure using instruments, such as non-deliverable forwards (NDFs), is creating an FX-induced working capital squeeze for some corporations. Those organisations sourcing in China and selling in US$ to, for example, large US retailers are finding the working capital required (in US$ terms) to produce their goods expanding sharply. Combined with high hedging costs, this means that corporations in this situation find themselves left with two alternatives:
In practice, some of the companies attending the Hong Kong meeting were using a mixture of these alternatives. Where they were undertaking production in-house (rather than sourcing from third party suppliers), they were ramping up production in their facilities in countries such as the Philippines and Vietnam at the expense of China. At the same time, they were hedging just a percentage of their FX risks and only out to about three or four months ahead.
The discussion of this particular problem was symptomatic of the broader issue of the impact of US$ weakness, which was also debated at some length at the Hong Kong meeting. Apart from RMB, the difficulties and costs of hedging other Asian currencies against US$ was creating a significant working capital issue.
Inevitably, the issue of trapped cash in China was raised at the Hong Kong meeting. One possible solution mentioned by a number of attendees was the use of a locally incorporated Chinese holding company. It was acknowledged that a Chinese holding company could potentially facilitate accessing trapped cash, sweeping and pooling – thereby improving the working capital position. The use of such companies, however, also raised a considerable number of questions:
An adjunct to the question of local holding companies in China is the use of commissionaire structures. These have proved quite popular as a method of improving cash management and an effective means of getting cash out of countries such as China. As a result, a range of corporations have opted to establish billing centres in Hong Kong. There is a potential downside to this approach, however, particularly in the current uncertain economic environment, where debtors are more inclined to delay payment. A billing centre in Hong Kong is unlikely to be able to exert as much leverage on a slow paying customer as a local accounts receivable (AR) department in the same city or province as the customer. Unless the remote billing centre has first class internal systems and connectivity to production facilities that will allow staff to quickly rebut any fictitious customer delivery/quality ‘queries’ over invoices, the corporation runs the risk of having its day sales outstanding (DSO) extended.
A fascinating facet of working capital in Asia is that the centralisation of processes such as AR does not necessarily scale with company size. In Europe and the US, the larger the corporation, the greater the likelihood that AR will be at least partially centralised into something like a shared service centre. By contrast, treasurers of quite substantial organisations in Asia may find themselves having to contend with multiple local business unit finance functions – each with autonomy with regard to their own AR, working capital and short-term cash investment. This inevitably makes improving the entire organisation’s overall working capital position extremely challenging.
This sort of situation tends to cast the treasurer in the role of diplomat. Local business units may have to be gently coaxed into releasing just the basic information about AR performance and cash balances – never mind the cash itself. The next stage is to try and extract the actual cash; leaving aside any technical considerations such as currency controls, this tends to raise a host of cultural issues. It is not uncommon for local business units to regard any locally generated surplus cash as ‘theirs’ – not the corporation’s. In companies with an entrepreneurial culture, this attitude may not be necessarily regarded as a bad thing by the main board.
Under these circumstances, the treasurer may have to accept that trying to force the issues of centralised working capital and cash management is simply not feasible. Possibly the best that can be achieved is to try and educate local business units to adopt the most efficient working capital practices possible on an individual basis. That in itself can prove another cultural challenge; in some locations, such as Hong Kong, there is a reasonably widespread acceptance of the concept of ‘just in time’ cash management. Unfortunately, in other locations in Asia there is a predisposition towards ‘just in case’ cash management, which results in unnecessary cash balances being maintained in non-interest bearing accounts.
In view of the number of companies in Asia supplying corporations in regions such as the US, where economic activity has sharply declined, there has been a significant upsurge in the use of factoring and invoice discounting. Rates for both services in Asia are extremely competitive even on a non-recourse basis.
The two primary reasons for the growth in factoring and invoice discounting are, as one might expect, cash flow and (in the case of non-recourse services) risk management. A secondary reason is simply the desire to improve the AR process by effectively outsourcing it to a specialist operation. In the case of larger corporations with lean working capital requirements, and especially those with significant exposure to the most afflicted segments of the global economy, the main attraction of receivables services is risk management. (Although some also find it convenient for additional month or quarter-end balance sheet window dressing.) For smaller organisations, particularly those with balance sheets unsuitable for raising conventional bank finance, the main attraction is the ability to access working capital funding at competitive rates.
The economic climate has obviously also been a generic factor in the growing demand for receivables services (as well as associated services such as debt insurance). This has been particularly apparent in businesses making larger ticket sales, such as car dealerships, where even a relatively minor slowdown in sales can have a significant impact in terms of overstocking and therefore working capital.
Much of the working capital discussion at the Hong Kong meeting focused on current issues such as US$ weakness and economic uncertainty, but certain ‘traditional’ working capital issues were also raised. While clearing systems in Asia have seen significant improvements recently, remittance information truncation in clearing remains a problem. AR departments often find themselves unable to apply cash correctly to customer invoices, which raises both working capital and credit control issues. Some banks, however, are now stepping into this space to facilitate the transmission of remittance information, particularly as part of supply chain financing initiatives.
Inevitably, the difficulties of cash flow forecasting were discussed. Attendees had a wide range of perspectives on this problem; some with relatively simple business models and centralised finance functions had little difficulty in generating extremely accurate forecasts. Other corporations with autonomous business units and finance functions were finding accurate forecasting nearly impossible.
The combination of economic uncertainty, the parlous state of many bank balance sheets and a weak US$ has predictably created a toxic working capital environment. The most creative treasurers are responding to this with a combination of initiatives. These include shifting sourcing, use of receivables services, education of business units on working capital best practice, and possible use of local holding companies in countries such as China.
Not all of these remedies can be implemented overnight, however, and several are heavily dependent upon the capabilities of the corporation’s banking partners. For example, the fact that receivables financing incurs a lower Basel II capital charge for a bank than outright lending becomes irrelevant if that bank lacks sufficient risk appetite and/or has an impaired balance sheet.
There is also the question of flexibility; does the organisation have (or can it create) sufficient flexibility so it is able to shift sourcing quickly to locations that are both cost effective and which facilitate (or at least do not impede) FX risk management? And does it have sufficient matching flexibility in its financial processes to support that shift efficiently?
Combine all these various factors and it becomes apparent that while efficient working capital management in Asia has probably never been more crucial, it has also never been more challenging.